Question

Please read the article “A better way to understand internal rate of return” of McKinsey, November 2015. As we have already learnt how to calculate IRR and main assumption about this project evaluation criteria do you see the way we should approach IRR suggested by McKinsey a useful recommendation? What are additional criteria on top of those we learnt in the class we can use?

Answer 1

Hi,

Please see the below answer to your question.

IRR (Internal rate of return) is the rate of interest at which the net present value/ worth of cash flows comes to equal to the minimum required rate of return of a project or investment. The minimum require rate of return is decided upon by the company’s management. This is a capital budgeting technique.

It basically shows the yield on an investment. This calculation takes into account time value of money. By TVM (time value of money) I mean, the money or amount which we will hold as of today’s date is more, than the same value if we hold it at a future date. This also shows the profit an investment would generate.

If IRR of any project is more than the company’s minimum required rate of return, then that investment is desirable as per the management. These projects are given high priority. For this Net Present Value is also considered. Net present value is the difference between the present values of cash inflows and cash outflows.

This calculation is easy to understand. However, we need to be careful about the interest rates. As this is based on predictions, which are not always correct.

Not only cash flows, but decision making, inflation rate, performance of the company, and also time invested by managers for these decisions. This method is best to calculate yield of long term investments.

Multiple projects may have same IRR, but which project to choose will depend upon the decision making of management of a company, as there are various aspects taken into consideration for evaluation.

IRR calculations may also be used in improvement in business functioning and performance. It also helps to keep a check on cash inflows and cash outflows.

Hope this helps :)