0:00

All right, now let me get to the one that I always think, that makes people's eyes

Â glaze over, kind of like the net present value discussion we had a few slides back.

Â But again, Internal Rate of Return is not a complicated concept,

Â it's not a complicated procedure, or calculation.

Â By far it's the best methodology of the alternative methodologies we've

Â been talking about in determining the appropriate investment.

Â So, an IRR has become, over the years, more respected.

Â Even their book rate of return and project payback are kind of,

Â they're kind of special purpose measures that people have used in the past.

Â I think people are getting away from that now, and they're looking more at IRR.

Â In fact, 20 years ago when I was in corporate,

Â we used IRR even back in those days.

Â So the IRR is much more respected as a methodology of valuating

Â investment proposal recommended by many, many textbooks.

Â 1:06

Okay, so I'm going to focus on the negative aspects of IRR.

Â Why am I doing that?

Â Well, [COUGH], excuse me, it's not because IRR is not a good thing,

Â or it's a deficient process, it's just that the deficiencies that

Â can arise in using IRR if you don't understand how this works is

Â less obvious to you than, let me see.

Â It's a less obvious problem and it's a lot more numerous so just less obvious.

Â So let's define what IRR means.

Â Okay, so Internal Rate of Return, IRR,

Â is defined as the discount rate that makes the net present value of

Â the entire cash flows over the life of the project equal to zero.

Â 1:58

The discount rate that makes the net present value of all the project

Â cash flows for the life of the project equal to zero, okay?

Â Okay, so let's talk about the IRR formula, how do you calculate IRR formula, what's

Â the rule that you should follow in using IRR to evaluate investment proposals?

Â Well, so here's the formula and it's not complicated.

Â So, you calculate an NPV of the project, but instead of using the discount rate,

Â the corporate cost of capital in your formula, in the denominator

Â of the formula, you come up with the internal rate of return to use.

Â 2:36

And so the formula basically says, cash zero,

Â meaning that my investment in year

Â zero + the value of the cash returned in year one.

Â At the internal rate of return for the project + the cash return in

Â year two at the internal rate of return for a project, plus,

Â go on until the end of the project, dash t means how many years the project lasts.

Â And it's basically at the internal rate of return or

Â you discount all of the cash flows back

Â using the internal rate of return of the project.

Â Now, back in the day, people had to calculate this.

Â Now anybody with reasonable Excel spreadsheet skills can go in there and

Â use that function.

Â There's an IRR function built into the program where all you have to do is

Â schedule your cash flows out a couple of columns.

Â The first year's always negative, right, because it's an outflow cash.

Â And the next years are probably positive, although they can be fluctuating,

Â we can talk about that a little later.

Â Let's just say the simple process is a negative number in year zero,

Â positive numbers in years one through whatever.

Â And then, luckily,

Â the program lets you make a guess on what the internal rate of return is.

Â And the program will actually iterate, until it figures out what the IRR is.

Â You don't even have to think about it,

Â you just have to put the calculation in the formula.

Â So, that's how you get the net present value using the IRR.

Â So, the rule that corporations follow is simple.

Â You accept the investment,

Â if the opportunity cost of capital is less than the IRR, less than the IRR, right?

Â And a lot of firms are using the IRR in preference to the net present value.

Â 4:37

But sometimes it doesn't work well, we'll talk about when it doesn't work well.

Â Okay, so the IRR works well in most cases, but there are some pitfalls

Â that you can run into you should be aware of and if you run into those,

Â you should use alternative ways of evaluating the project.

Â So the first pitfall is what they call lending and borrowing.

Â It simply means that the project doesn't have cash flows that decline

Â 5:02

as the discount rate goes up.

Â And that happens when you have uneven and irregular cash flows.

Â Uneven meaning, not the same flow of cash and

Â irregular means they're not happening year after year after year.

Â So if that happens, if you have a project like that, then you should use NPV.

Â That's a way to analyze that investment proposal.

Â There's another one that's actually funny to watch when you have Excel,

Â get into a calculation mood, that can happen, and you can actually

Â generate more than one internal rate of return on the same project.

Â And that happens because of changes in the timing of when cash goes out,

Â when cash comes in.

Â And essentially, if that happens several times in a project, and

Â I could schematically draw that for you, but

Â essentially if you look at the IRR curve,

Â let's say this is IRR, the cash goes up and it comes back down again.

Â It crosses it more than once.

Â If it crosses up more than once,

Â then that means you got two IRRs to the same project.

Â Simple solution?

Â Use NPV.

Â 6:10

And the next one is mutually exclusive projects, okay.

Â So depending upon how the cash flows fall, a project can have

Â a lower internal rate of return, but a higher net present value.

Â And it goes back to kind of the way IRR works, right?

Â Because it's discounting everything back to the present time.

Â So, in that case, when you have mutually exclusive projects,

Â you want to use net present value as a tiebreaker.

Â And finally, the fourth pitfall is if you have differences between short and

Â long term interest rates, the rule, the IRR rule, says accept any

Â project when the IRR is higher than the corporate cost of capital they often are.

Â But if there's more than one r, which one should you use, right?

Â 7:05

There's more than one r when you have, let's say, a short term interest rate for

Â short term projects and the long term interest rates for long term projects.

Â That happens, use net present value.

Â So, the verdict on IRR is, is that it may be more difficult to use than NPV.

Â But if you use it correctly, it should give you the same answer.

Â It's much,

Â much better than using [INAUDIBLE] rate of return payback periods.

Â And firms who encourage their managers to look for

Â projects that have high IRRs can lead to a problem.

Â And that is, number one, they try to, let's say,

Â they try to make their

Â IRRs as high as possible by maybe being a little more loose with their numbers.

Â And as we looked at, in one of our earlier examples,

Â high internal rate of return projects typically come from short lived projects

Â that have a initial

Â investment and then you have the high returns early in the period.

Â But if you have, like another example A, B, C,

Â the two projects, B and C, both had, they were short term.

Â And the IRR would've said to you, invest in those.

Â But if you remember in project A, that was the most reasonable one to use, okay?

Â So that can be a problem.

Â So those are the kind of alternative methods that are often used by corporate

Â finance to evaluate your investment portfolio.

Â Again, I think net present value is the best one to use.

Â