Internal Rate of Return and the Investment Behavior of a firm

- Dr Sandeep Kulshrestha

financewisdom@easy.com

There are Professors across the world who teaches Financial Management in a very
scientific way. It is good to explain financial terms scientifically to those who have either
an idea or knowledge of these terms. One of the mind-boggling financial tools is the
Internal Rate of Return which is commonly used to analyze the efficacy of an
investment proposal. Internal Rate of return is also known as discounted cash flow rate
of return.

In more specific terms, the IRR of an investment is the interest rate at which the net
present value of costs (negative cash flows) of the investment equals the net present
value of the benefits (positive cash flows) of the investment.

I will define Internal Rate of return as “a calculation of such discount rate which
brings equality to the net present value of the initial investment with the net
present value of future returns”.

Before understanding this further, let us understand few concepts, as below;

Net Present Value (NPV): Suppose you have $100 in hand today and if invested in a
project, you may get it back as a return in three years. Do you think it is a good return?
Can you buy same things in $100, three years from now, as you buy now? The answer
is “no” as the value of the $100 will not be same in future as it is today. If you get say
$110 after three years, you may feel good because your money gets appreciated. But
still, would you not be interested to know what is the present value of that $110, so that
you may understand whether it’s worth investing. Suppose the net present value of
$110 which you will get after three years still comes to be $100, will you still invest? The
answer again is “no”. So, you will definitely be interested if it comes to be more than
$100. Hence, Net Present Value is the present value of the future benefits which is
calculated easily from the net present value tables available.

Cash Flows: The inflow and outflow of cash in any business venture or investments.
You invest $100, which is a cash outflow and you get $110 after three years, which is a
cash inflow

Discount Rate: The rate used to discount future cash flows to the present value is a
key variable of this process. A firm's weighted average cost of capital (after tax) is often
used as a discount rate but many people believe that it is appropriate to use higher
discount rates to adjust for risk or other factors. Another approach to choosing the
discount rate factor is to decide the rate which the capital needed for the project could
return if invested in an alternative venture. If, for example, the capital required for
Project A can earn five percent elsewhere, use this discount rate in the NPV calculation
to allow a direct comparison to be made between Project A and the alternative. Hence,
discount rate is the outcome of any firm’s decision of what exactly should be the criteria.
Suppose I own a firm and I wish to invest in a new project worth $100 and my discount
rate is 5% with cash outflows and inflows as follows

Year Cash Inflow/Outflow Present Value Present Value

Factor @ discount
rate of 5%
0 -100 - -
1 40 0.952 38.08
2 50 0.870 43.5
3 40 0.790 31.6
113.9

In the above example, the net present value comes to be $ 113.9, higher than $100 but
as an investor I am a little restless. Now I need to know what is that discount rate which
would make the net present value of cash inflows equal to $100, so that I can see the
effective benefit or yield and see a realistic picture. If 5% makes NPV 113.9, what is that
rate which will make it $100? In this case, now we have to do some guesswork and
think of an assumed rate, say 7% and then we calculate NPV based on that and
suppose NPV comes to be say $105, we have to again use a higher discount rate, to
arrive at such discount rate which makes the present value of cash flows and inflows
equal to zero (or a NPV equal to $100)

Financial wizards look to IRR and often base decisions on. In reality, most firms would
borrow funds at a rate close to their own cost of capital, not at the IRR rate. In the eyes
of the financial specialist, therefore, an investment with an IRR above the real cost of
borrowing (above the current cost of capital) is seen as a net gain, because the cost of
the investment is lower than the rate of return.

The Investment behavior of a firm is a collective thought process involving the decision
makers in a firm, including the Chief Executive and the CFO and any project is
evaluated with a view of understanding the cost benefit analysis and IRR is at times a
psychological way of feeling positive about an Investment, especially so when the IRR
is substantially higher than the cost of capital or any other discounting methodology
used. Mathematical models in Finance are pertinent to the decision making process and
things become little easier by using matrix like the Internal Rate of Return.