Why Use Internal Rate of Return Calculations in Financial Modeling?
Internal rate of return (IRR) is a financial metric use for capital budgeting and business valuation. It aids in deciding whether to pursue an investment or not. IRR is presented in percentages where the Net Present Value (NPV) equals zero and should be higher than the discount rate (predominantly Weighted Average Cost of Capital). The considerations for computing IRR are the initial investment, future cash flows, and discount rate (or WACC).
When done manually, IRR computation is a trial and error. For faster calculation, Excel has a built-in formula for computing IRR.
IRR Calculation in Excel
For IRR calculation in Excel, you have to input or reference cells for the initial investment and cash flow series. The “Guess” portion can be left blank, and Exel will have a default guess of 10%. You can compute IRR using this Excel Formula below.
Function Formula: = IRR (values, guess)
Where:
Values — is the required argument that contains the cells for the investment cost and the series of cash flows. The investment cost is a negative amount since it’s a cash outflow.
Guess — this is the percentage that you estimated is closest to the answer for IRR.
Below is a sample computation of IRR in Excel.
Why Use Internal Rate of Return?
IRR is presented in percentage, which makes it handy when assessing various projects. Projects with high IRR are the priority in terms of implementation. For those projects that reach your desired return, you can put them on the waiting list and for later implementation once the budget frees up. All factors consider when computing IRR is internal. The result is not affected by changes in stock prices or business market value. It provides you with an internal assessment of your project before taking into account the market consideration.
IRR is widely used by private equity, venture capital, start-ups, and project finance to aid them in project valuation and capital budgeting decisions. It helps them decide whether to pursue the project or not. IRR sets the threshold of the return rate when accepting and pursuing a project.
Nevertheless, IRR is not a stand-alone financial metric where you solely depend. It would be best to utilize other financial metrics such as the Net Present Value, Payback Period, and EV/EBITDA. Utilizing various metrics would fill in the flaws of the other methods to provide a more reliable business valuation.
Though IRR has its share of disadvantages, it is an excellent financial planning tool to utilize and assess internal business valuation and provide a valuable business perspective.
eFinancialModels offers a variety of financial model templates with IRR calculation. Every financial template is equipped with financial metrics and key drivers specific per industry. These templates are fully editable, where you can easily input your assumptions and overwrite some of the assumptions to cater to your specific financial modeling needs.
