IRR (Internal rate of return)

It’s not really very important, however…..

Let’s say that a project’s IRR is 20% and the cost of capital is 10%. Obviously, a worth while project.

A very simple project that returns an IRR of 20% is:

T0 Invest 10,000
T1 Receive 6,000
T2 Receive 7,200

At a discount rate of 20% the NPV is: -10,000 + 6,000/1.2 +7,200/(1.2×1.2) = 0

ie 20% = IRR

Instead of using the 1st year’s cash receipt when it is received, it could be set aside until the second year’s cash was also received. It wouldn’t just be left dormant, but would be invested eg in an interest-bearing bank account. However, the only way that 20% would remain the IRR is for that cash to be placed on deposit at 20% so that the cash flows available to the company would be:

-10,000 + [6000 x 1.2 + 7,200]/1.2 x 1.2 = 0

So implicit in the calculation is that the earlier cash receipts are reinvested at the IRR.