Time Value of Money: Defining the IRR
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01:21 – Defining the IRR
02:35 – Value of the IRR
08:30 – Formula to calculate the IRR
11:15 – Method of Trial and Error to calculate the IRR
13:40 – Integrated formula of the IRR in Excel
16:05 – Conclusions
A very important parameter to consider in financial analysis is the Internal Rate of Return.
Per definition, it is the interest or discount rate for which the Net Present Value is equal to 0. When you consider the calculation of a mortgage and the monthly payments and you would calculate the IRR on them, you would see that the IRR is equal to the interest rate charged by the lender.
The IRR is the yield of the investment.
When a company uses money, it is not for free. There is a cost to be paid which can be calculated and is expressed as a percentage of the different ways to invest in the company and use money. When we would consider as an only investment a bank loan, then the WACC would be equal to the percentage of the loan.
When considering investments, it is clear that, we not only have to make a profit, but that we also have to compensate for the cost of lending money, hence the yield of our investment should be larger than the rate of the loan, or the WACC.
In some cases, eg. when there is a higher risk factor, we can add some extra profit to the yield to compensate for the risk, in that case, we speak about the Required Rate of Return, which is higher than the WACC.
In normal cases, the IRR will not be used to select between projects or investments, but it will be used as a cutoff rate. Projects with an IRR equally to or higher than the RRR will be further evaluated using other parameters, while the projects with a lower IRR will not be considered.
When we look at the formula of the NPV and replace the discount rate with the IRR, it becomes clear that it is not possible to deduct the IRR directly from the formula. However, we can calculate the IRR by using a mathematical technique called “Trial and Error” where we step ey step close in on the IRR or come closer to finding the yield for which the NPV is equal to zero. Once we come close enough, typically when we have a precision of 2 decimals, we can stop the calculation. How to do this calculation, will be explained in the next video.
Excel and other programs provide guilt in formulas that will give us “immediately” the requested IRR. The formula in Excel is given by:
Here we select all the values with their respective signs and the formula will calculate the IRR. However, in some cases (after 20 interactions) it is possible that the program does not give a result and then we have to provide a [guess] to start closer to the value of the IRR.
Nore in the next video where we will look deeper into the step by step calculation of the IRR
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