Internal Rate of Return (IRR)
Vložit
- čas přidán 15. 07. 2024
- Internal Rate of Return explained in a clear and simple way. NPV (Net Present Value) and IRR (Internal Rate of Return) are very closely related. I strongly advise you to study Net Present Value before Internal Rate of Return! So if you don’t know how NPV works, or only have a very basic grasp of the concept, then watch my Net Present Value video first • Net Present Value (NPV... to become an NPV expert, and then come back to watch this Internal Rate of Return video.
⏱️TIMESTAMPS⏱️
0:00 Introduction to IRR
0:37 NPV calculation
1:07 NPV and IRR relationship
2:08 IRR definition
2:51 Internal Rate of Return example
3:44 NPV IRR WACC summary
In a calculation of Net Present Value, we take future values and convert them one by one to present values, using a discount rate or weighted average cost of capital, which in this example is set at 20%. The further out in the future the nominal amount, the lower the present value equivalent. To get to NPV, you now simply sum the present value amounts. The Net Present Value in this example is $35.
So how do NPV and IRR relate to each other? With NPV, you start off quantifying the nominal cash flows over the years for your project. You use the discount rate (also called WACC or hurdle rate) to calculate present values of the estimated project cash flows. The last step is to calculate the Net Present Value (or NPV) by summing the discounted cash flows.
IRR basically swaps steps 2 and 3. Just like in the NPV calculation, you start off quantifying the nominal cash flows over the years for your project. You then set the Net Present Value in the formula at zero. You can now calculate IRR, which is the output variable or dependent variable.
Here are the steps to use in the NPV formula. Step 1: start with the nominal cash flows. Step 2: apply the WACC or discount rate as an input variable. Step 3: Calculate NPV as the dependent variable.
Here are the steps to use when you want to determine Internal Rate of Return. Step 1: start with the nominal cash flows. Step 2: set NPV to zero. Step 3: Calculate IRR as the output variable.
In this video, I have shown you the “trial and error” step by step approach to determining IRR, to show you how the concept works. Now that you understand IRR, you can go to the next step of calculating IRR efficiently, and that’s where Excel comes in: • IRR in Excel
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: CZcams videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
Enjoyed this video? Then please subscribe to the channel, and let's explore the difference between IRR and WACC: czcams.com/video/ZuH_q5crAWg/video.html
Yes enjoyed it ☺️
Yes enjoyed it very much, Thank you.
Whos here and then watch NPV videos and then came back here hahahahaha
Yep, they are like siamese twins! ;-)
Hahaha
I'm taking a financial accounting class entirely online, which I find very challenging. Not having a professor physically to go over the material, and not being able to ask questions and get responses in person rather than emails 3-5 days later is a really hard way to learn. This course has seriously been very challenging for me, just understanding the concepts and what all these financial ratios and calculations mean in the financial world. Textbooks are not always easy to understand either. I want to thank you for simplifying these formulas, explaining the meanings in "normal" English vocabulary, and showing how to use them or calculate them in a very easy way to understand. THANK YOU THANK YOU THANK YOU. After watching your videos on FV, PV, NPV, and now IRR, my brain feels so much better. Muchas gracias.
Thank you for the very kind words, Marlen! I am so happy to hear that. My NPV IRR WACC playlist might have some more useful videos for you: czcams.com/play/PLKbmcnUUQMlkkCqQs7M_b6ktTDLITcRoG.html If you have any (short) questions, please post them as a comment to any of the videos, I usually get back on them within a day. 🙂
Best explanation on CZcams - and given in a beautiful Dutch accent too!
Thanks! 😃 Please subscribe to the channel! I have a playlist for you with videos covering IRR, NPV, WACC, payback, hurdle rate, hope there are more useful videos in there for you: czcams.com/video/N-lN5xORIwc/video.html
I can bet he is jamaican 🙄
I just love this guy. I know nothing of Finance. I've taken a course and your videos strengthen me considerably in such an interesting way.
Fantastic! Thank you so much for the kind words, Saptarshi! I try to make the videos as accessible as possible. Enjoy! Please subscribe, and the spread the word about the channel. 🙂
I never comment on these vids but I have a final in an hour and you just explained this to me in 5 mins what my professor couldnt in an entire lecture. THANK YOU SO MUCH!!!
Happy to help! Hope your final went well. Let me know!
Visuals made it work for me, now its clear! Very good explanation
Thank you very much!
Thanks for explaining how NPV and IRR are related! That’s the piece I was having a bit of trouble with
Happy to help! I have a whole series on NPV, IRR, WACC and related topics, including a tutorial on how to calculate these in Excel. For myself, playing around with these numbers in a spreadsheet brings me to understand the concepts better: czcams.com/video/N-lN5xORIwc/video.html
with so many years i try to understand this.. it just sums it all up in 5 minutes
Happy to help, Awadz! What might also be useful to watch is my video on WACC vs IRR czcams.com/video/ZuH_q5crAWg/video.html&pp=gAQBiAQB or simply to play around with IRR a bit in Excel czcams.com/video/L0JCg5TXudc/video.html&pp=gAQBiAQB
i have been trying to teach myself financial advice and your videos have been very helpful. thank you
You are so welcome! Have a look as well at this summary video of what I think are 5 big ideas in finance: czcams.com/video/iR7b2NjgAO8/video.html
Amazing explanation. Indeed if you understand something you can explain it to a child.
Thank you kindly! 😎
Deze video's helpen me zo erg nu ik op de uni zit👍
Mooi zo!!! Veel succes. Ik heb ook video's over NPV en WACC voor je.
Very good explanation. Still trying to get my head around IRR vs MIRR calculations in MS Excel for a series of forestry operation projections!
Glad it was helpful! I must admit that I have never used MIRR myself, however I do discuss useful related concepts like the crossover rate and the profitability index in videos in my NPV IRR WACC playlist (scroll down to the bottom of the list): czcams.com/video/N-lN5xORIwc/video.html
Thank you so much
Thank you this good ideas for producer.!!!!!!!!!!!!!!!
Very helpful. Thank you!
Nice to hear that! Related topics in this playlist: czcams.com/video/1O-DbtVueMw/video.html
Hi! Thanks for the super clear explanation. Your videos really help me a lot. I have a request: is there any chance you could explain what it means when there are multiple IRRs in a project and how to interpret this? Thank you!
Thanks for the kind words! I have personally not come across any cases with multiple IRRs, but you could do a search on the terms "multiple IRRs" and see if CZcams comes up with any recommended videos...
Can't thank you enough!
Happy to help!!!
Love your work. Great voice too.
Thank you so much 😀
This has really helped me ❤ thank u
Wonderful to hear that! Please spread the word!
Very well explained.
Thank you, Sasi! 🙂
Thank you very much!
You're welcome, Sayantan! Happy to help.
Excellent short lecture
Many many thanks
Wow, wonderful content!
Thank you!!!! Please spread the word to friends and colleagues, and have a look around the channel. I have videos on NPV and WACC that might be useful for you.
Thank you for the video, you save me
Happy to help! It might be useful to watch other videos from the same playlist as well, like WACC vs IRR: czcams.com/video/ZuH_q5crAWg/video.html&pp=gAQBiAQB
Thanks so much for this simply and clear explanation. I am studying construction management and this is one tool we are using for Project appraisal, to analyse what projects are selected and how.
Can I make a request? And I'm sorry if this is a stupid question. I get how to calculate the IRR, but I still can't really understand why. What is the benefit? No one really ever tells you why.
Hello! I love it when people question why we bother to make certain calculations in the first place. 🙂 In the case of IRR, you are trying to figure out (upfront, based on assumptions that could later turn out to be somewhat accurate or wildly inaccurate) whether a project is worth doing. As you already mentioned: accept or reject a project. And on top of that, for those projects you accept, which one(s) to pursue first? Basically, the higher the IRR, the more attractive the project. However, you also want to make sure that the IRR meets at least a minimum requirement. So here's an example. Let's assume we have a hurdle rate of 15%, IRR for project A of 18%, IRR for project B of 22%, and IRR for project C of 14%. Both projects A and B exceed the hurdle rate, so they generate value and should be pursued. A exceeds the hurdle rate by 3%-points, and B by 7%-points. Project C falls short of the hurdle rate by 1%-point. So relatively speaking, B is more attractive than A, as the positive "gap" of IRR vs hurdle rate is bigger. As a business leader, I would first execute B, and then A. After that, I would review the project economics of project C again, to see if I can cut out any part of its investment and/or increase the benefits, to see if I can get it over the hurdle rate in a second attempt. See also my video WACC vs hurdle rate czcams.com/video/8EyFLdOTuHU/video.html and the video on NPV IRR payback scenarios czcams.com/video/1ZTIwmn1Cm0/video.html
Excellent!
Glad you liked it!
I love you. TY so much.
Happy to help! Have a look at the related videos on WACC, discounted payback, etc as well: czcams.com/video/1O-DbtVueMw/video.html&pp=gAQBiAQB
Best then a course I've taken from Coursera , omg was like I'm in the desert
Welcome! And thank you for the kind words.
What is the course?
Excellent!!
Thank you! ☺
great work
Thank you!!! More on NPV IRR WACC etc. in this playlist: czcams.com/video/N-lN5xORIwc/video.html
I understand how to calculate IRR but I don't understand how to interpret IRR in a project. If IRR is a big number, what does it implies?
The higher the IRR, the more attractive the project. IRR should be at least higher than the WACC or discount rate.
Alternatively, the higher the IRR, the more unrealistic the assumptions might be. 😉
Awesome!
Thank you, Gino! More videos on related concepts in this playlist: czcams.com/video/N-lN5xORIwc/video.html
This is a God send thanks sir and God bless you!
You are very welcome, Chris!
Thank you so much for the videos. And I love your Dutch accent. What I still not fully grasp is the non technical meaning of IRR. Does that mean that if IRR is less than or equal to WACC, the project should not be pursued? And whats the difference between IRR and Rate of Return? Just the time?
Thank you for the kind words! IRR measures the overall return of a project, taking the time value of money into account. Yes, you should look for projects with an IRR higher than the WACC or hurdle rate. I made a specific video on IRR vs WACC, maybe that helps: czcams.com/video/ZuH_q5crAWg/video.html
"Rate of return" is a more loosely used term, some people mean ROI with it, others IRR, so I tend to stay away from using that term.
Got it sir 👍
Great! Enjoy using it!
Hi, thanks for the informative video! However, is there an algebraic formula to use instead of trial and error to solve for the IRR? So for example since we set the NPV to 0, it means that the sum of all the cash flows in present value must be equal to the investment in present value. So we equate the [400/(1+irr)] + [400/(1+irr)^2] + ... to 1000 and then find for the value of irr? Although I do think this method might be long and tedious, I was wondering if there is a clear cut formula for determining IRR. Thanks for the help!
Hi Rishi! There is no clear cut formula that I know of, but be my guest in trying to derive it. I simply use the Excel formula for IRR, or the trial and error process: czcams.com/video/L0JCg5TXudc/video.html
@@TheFinanceStoryteller Haha I tried deriving it but I realised it is not very feasible, especially if the number of years increases, because the unknown is raised to higher powers. I realised it actually works if you use a graphing calculator and find the x intercepts but then again, excel is simply faster and more practical. Thanks anyway!
Yep. :-) Let's use the tools we have at our disposal (like Excel and calculators), and get to a trusted result in an efficient way. Always good to verify that the outcome of the calculation is correctly calculated. ;-)
so is there no other way to calculate IRR than human trial and error? (not using excel or a calculator formula)
None that I know of.
you just saved my life hahaa😅🙌
Happy to help! Related topics that you are likely to need sooner or later in this playlist: czcams.com/video/1O-DbtVueMw/video.html
Great video. What im still having trouble with is: the IRR is the always the rate at which you break even. So therefor when comparing two projects, with differing IRR, both projects will just be breaking even at their IRR...so...what difference does it make? if one project has a higher IRR than the other, its still just breaking even at that IRR rate.
At a certain IRR, the project is breaking even. But if you compare the IRR to the hurdle rate and the hurdle rate is lower, then youre making money. How can you be doing both at the same time? its confusing...
You're thinking in the right direction, with just one more step to make. Let's assume we have a hurdle rate of 15%, IRR for project A of 18%, IRR for project B of 22%, and IRR for project C of 14%. Both projects A and B exceed the hurdle rate, so they generate value and should be pursued. A exceeds the hurdle rate by 3%-points, and B by 7%-points. Project C falls short of the hurdle rate by 1%-point. So relatively speaking, B is more attractive than A, as the positive "gap" of IRR vs hurdle rate is bigger. As a business leader, I would first execute B, and then A. After that, I would review the project economics of project C again, to see if I can cut out any part of its investment and/or increase the benefits, to see if I can get it over the hurdle rate in a second attempt. See also my video WACC vs hurdle rate czcams.com/video/8EyFLdOTuHU/video.html
Hope this helps! Let me know.
@@TheFinanceStoryteller Does this mean that Project B will pay back its costs faster than other projects?
Hi, does it always have to be zero or the NPV value that is closest to zero but not negative?
My preferred way is to calculate IRR in Excel: czcams.com/video/L0JCg5TXudc/video.html&pp=gAQBiAQB Set NPV to zero, calculate IRR with the formula, and then round to zero decimals or one decimal.
Thank you ❤, but does this mean if you go higher then the 22% discount rate or now our IRR it's actually bad because our NPV becomes negative. So our limit in this case of IRR/Discount rate is 22% because otherwise we would lose profitability and become unprofitable because our NPV becomes negative if it is higher than 22%, is this correct?
Hi Dylan! You are largely correct, but I would phrase it slightly differently. At 22% discount rate, you are indifferent between doing or not doing the project, as the NPV is zero. At higher discount rates (over 22%), you would get a negative NPV, meaning that the project destroys value if it is pursued. At lower discount rates (below 22%), you get a positive NPV, meaning the project creates value when pursued.
I have a separate video explaining the difference between IRR and discount rate (aka WACC), this might be useful to watch: czcams.com/video/ZuH_q5crAWg/video.html
@@TheFinanceStoryteller Oh ok ofcourse, now I understand it better thank you. Basically, we need to find the discount rate that makes the NPV zero, which in this case is 22%. This rate is the IRR, which tells us if the project is profitable or not and the NPV indicates this together with the discount rate/IRR. If a higher discount rate (WACC/RRR+components) results in a negative NPV, it means the project or investment is not profitable, and vice versa with a positive NPV.
The other thing I need to be careful about is between gross IRR and net IRR. Net cash flow or FCF will most of the time be a net IRR if used in an IRR calculation if I'm not wrong?
Sorry for a stupid question: in min 1.47 say and show NPV is "NPV = summing the discounted cashflows" a moment later in 2:01 you subtract the investment from the discounted cashflows and call this the NPV. So what is the NPV than?
For the investment, the future value and the present value are the same, as the investment happens today. NPV does take the investment amount into account (by subtracting it).
I'm sorry I was distracted by the voice, sounds like Niki Lauda teaching me finance.
You can always switch off the sound, and switch on the subtitles. ;-) I consider your comment a compliment, he was a great driver.
calculator would do here :( I gotta practice that
Can anyone tell me in very simple words why IRR needs to be calculated for investment? How will you explain it to Non-Finance person. is it our actual return on investment? How can you find hurdle rate to compare? can we consider minimum expected profit rate as hurdle rate?
Several projects are competing for the same investment budget. We cannot invest in all of them at the same time. Therefore we need to use methods like payback period, net present value, and internal rate of return to "force rank" the projects from most attractive to least attractive. Payback period is intuitive to most people, the shorter the better. Net present value is an amount, translated back over time to "today's equivalent", the higher the better. Internal rate of return is a percentage representing the overall return of the project, it is not the same as return on investment, and in comparison between projects the higher the percentage the better. I have follow-up videos for you on WACC vs IRR czcams.com/video/ZuH_q5crAWg/video.html and WACC vs hurdle rate czcams.com/video/8EyFLdOTuHU/video.html
How does the formula change if the investment is split over 2 or 3 year time period?
Best to play around with some scenarios in Excel, and learn how IRR changes (up or down) by doing: czcams.com/video/L0JCg5TXudc/video.html
You should know that you just saved one college student in Korea from the HeLL fnan class
Great to hear that! Please tell your fellow students. Have a look as well at the related videos on WACC, profitability index, discounted payback etc czcams.com/video/1O-DbtVueMw/video.html&pp=gAQBiAQB
Greetings back from the Netherlands!!!
In this example of IRR 22%, can I say that the benefits (Cash inflows in 4 years) of this project not just recover the investment cost of $1,000 but also give you a return of 22%?
Hi Jason! When you talk about recovering the investment of $1000, you are referring to the payback method. IRR is very different from that. The IRR calculates a rate of return for an investment, taking the time value of money into account: czcams.com/video/gkp-7yhfreg/video.html
@@TheFinanceStoryteller Thanks a lot!!
What is the difference between IRR and return on investment? Is this same..?
The central question for the ROI method is: what % annual return do I get on my investment? Using the same example as in the video, Return On Investment is the annual benefit of $400 divided by the investment of $1000, so 40% ROI for four years.
IRR takes the time value of money into account. In IRR calculations, the main question is: what is the discount rate that makes the NPV equal to zero? A discount rate of (rounded up) 22% gets us to an NPV of $0.
Hii I just wanted to know we calculated all the benifits with rate of 22 percent and the total is 998 and 1000-998 is 2 so we got NPV of 2 how come 0?
Rounding. I rounded to 22% with no decimals, as this is a video focusing on understanding the concept. The actual IRR is 21.86226961%. Give that a try in Excel.
at minute 3:38 it says that 400/(1.22)^3 = 221, however its 220.28 aka 220 rounded. Or am I missing something? because this small adjustment made my NPV 2 instead of 0
Hello Alexios! I didn't want to go to too any decimals in this video, so I am showing a nice round 22% as the IRR, whereas the true answer is 21.862%.
Is ther any formula also to calculate IRR
Nope, not really. And if there is, it is way beyond my mathematical skills. Play around with it in Excel, and you see how IRR "reacts" to changes in inputs: czcams.com/video/L0JCg5TXudc/video.html
Very strong Dutch accent
Dat klopt, Hans! 🙂
How this give us any idea of a return ? It is basically a break even point ? Where is the return i don't get it. I feel more like its a limit at which our project won't create any value ?
Your second and fourth sentence are spot on!!!
But why IRR is called as internal rate of return ? Why not breakeven rate?
I don't know, and I wouldn't worry too much about it.
I've watched at least 10 videos and a lecture on IRR and every single time I am confused. Too many letters being thrown out there and not enough expanation of what the definition of things are.
Sorry to hear that, Dan! If it's any consolation, IRR confuses a lot of people. I would suggest to only start studying it once you understand all the ins and outs of Net Present Value (NPV). IRR is the discount rate at which the net present value of all cash flows from a particular project is equal to 0. Perhaps my video on WACC vs IRR can help czcams.com/video/ZuH_q5crAWg/video.html or if you learn by doing then the video on how to calculate IRR in Excel czcams.com/video/L0JCg5TXudc/video.html
I didn't get you well, especially with the Internal Rate of Return's formula
Sorry to hear that, Alberta! IRR is a tough one to understand. Maybe this related video on NPV and IRR can help: czcams.com/video/Fw5-wccViOM/video.html
Je hoort zo hard dat hij Nederlands is
Klopt. Maar de belangrijker vraag is: begrijp jij inmiddels hoe IRR werkt?
@@TheFinanceStoryteller Ik bedoelde het negatief sorry meneer ik vind het fijn dat u video's maakt. Over de IRR ik snap alleen niet hoe het zit als je meer IRR's hebt.
this is more confusing than what i read in my book. visuals would have helped
Sorry to hear that. Good thing you are trying multiple ways to understand the concept. Maybe playing around with it in Excel might help: czcams.com/video/L0JCg5TXudc/video.html
Nederlands?
Jazeker!!! Valt het op? 😉
how the fuck is this the easy version
How about this version of playing around with the IRR concept in Excel instead: czcams.com/video/L0JCg5TXudc/video.html