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Internal Rate of Return, DCF, NPV

Internal Rate of Return (IRR) is a metric used to estimate the profitability of potential investments by calculating the discount rate that results in a net present value (NPV) of zero for the investment's cash flows. IRR relies on the same calculation approach as NPV. The higher the IRR of a project, the more desirable it generally is to undertake.

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Mihir Asher
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133 views4 pages

Internal Rate of Return, DCF, NPV

Internal Rate of Return (IRR) is a metric used to estimate the profitability of potential investments by calculating the discount rate that results in a net present value (NPV) of zero for the investment's cash flows. IRR relies on the same calculation approach as NPV. The higher the IRR of a project, the more desirable it generally is to undertake.

Uploaded by

Mihir Asher
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of

potential investments. Internal rate of return is a discount rate that makes the net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same
formula as NPV does.

What is 'Internal Rate of Return - IRR'


Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of
potential investments. Internal rate of return is a discount rate that makes the net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same
formula as NPV does.

The following is the formula for calculating NPV:

Where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be
calculated analytically, and must instead be calculated either through trial-and-error or using
software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank
multiple prospective projects a firm is considering on a relatively even basis. Assuming the costs
of investment are equal among the various projects, the project with the highest IRR would
probably be considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return" (ERR) or "discounted cash flow rate of
return (DCFROR)." The use of "Internal" refers to the omission of external factors, such as the
cost of capital or inflation, from the calculation.

What is 'Net Present Value - NPV'


Net Present Value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze
the profitability of a projected investment or project.

The following is the formula for calculating NPV:

Where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or
investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally,
an investment with a positive NPV will be a profitable one and one with a negative NPV will
result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that
the only investments that should be made are those with positive NPV values.

When the investment in question is an acquisition or a merger, one might also use the
Discounted Cash Flow (DCF) metric.

What is a 'Discounted Cash Flow (DCF)'


Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts them,
using a required annual rate, to arrive at present value estimates. A present value estimate is then
used to evaluate the potential for investment. If the value arrived at through DCF analysis is
higher than the current cost of the investment, the opportunity may be a good one.
Calculated as:

DCF = [CF1/(1+r)1] + [CF2/(1+r)2] + ... + [CFn/(1+r)n]

CF = Cash Flow

r= discount rate (WACC)

DCF is also known as the Discounted Cash Flows Model.

BREAKING DOWN 'Discounted Cash Flow (DCF)'


Several methods exist when it comes to assigning values to cash flows and the discount rate in a
DCF analysis. But while the calculations involved are complex, the purpose of DCF analysis is
simply to estimate the money an investor would receive from an investment, adjusted for the
time value of money.

The time value of money is the assumption that a dollar today is worth more than a dollar
tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth
$1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must consider $1.05 a year
from now to be worth $1.00 today. When it comes to assessing the future value of investments, it
is common to use the weighted average cost of capital (WACC) as the discount rate.

For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's
future cash flow growth. We would start by determining the company's trailing twelve month
(TTM) free cash flow (FCF), equal to that period's operating cash flow minus capital
expenditures.

Say that Company X's TTM FCF is $50m. We would compare this figure to previous years' cash
flows in order to estimate a rate of growth. It is also important to consider the source of this
growth. Are sales increasing? Are costs declining? These factors will inform assessments of the
growth rate's sustainability.

Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then
5% in the following three. After a few years, you may apply a long-term cash flow growth rate,
representing an assumption of annual growth from that point on. This value should probably not
exceed the long-term growth prospects of the overall economy by too much; we will say that
Company X's is 3%. You will then calculate a WACC; say it comes out to 8%.

The terminal value, or long-term valuation the company's growth approaches, is calculated using
the Gordon Growth Model: Terminal value = projected cash flow for final year (1 + long-term
growth rate) / (discount rate - long-term growth rate).

Now you can estimate the cash flow for each period, including the the terminal value:
Year 1 = 50 * 1.10 55
Year 2 = 55 * 1.10 60.5
Year 3 = 60.5 * 1.05 63.53
Year 4 = 63.53 * 1.05 66.70
Year 5 = 66.70 * 1.05 70.04
Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these projected cash
flows, adjusting them for present value, using the WACC:

DCF of Company X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 /
1.085) + (1,442.75 / 1.085) = 1231.83

$1.23 billion is our estimate of Company X's present enterprise value. If the company has net
debt, this needs to be subtracted, as equity holders' claims to a company's assets are subordinate
to bondholders'. The result is an estimate of the company's fair equity value. If we divide that by
the number of shares outstanding—say, 10 million—we have a fair equity value per share of
$123.18, which we can compare with the market price of the stock. If our estimate is higher than
the current stock price, we might consider Company X a good investment.

Limitations of Discounted Cash Flow Model


Discounted cash flow models are powerful, but they are only as good as their inputs. As the
axiom goes, "garbage in, garbage out". Small changes in inputs can result in large changes in the
estimated value of a company, and every assumption has the potential to erode the estimate's
accuracy.

What is 'Capital Budgeting'


Capital budgeting is the process in which a business determines and evaluates potential expenses
or investments that are large in nature. These expenditures and investments include projects such
as building a new plant or investing in a long-term venture. Often times, a prospective project's
lifetime cash inflows and outflows are assessed in order to determine whether the potential
returns generated meet a sufficient target benchmark, also known as "investment appraisal."

BREAKING DOWN 'Capital Budgeting'


Ideally, businesses should pursue all projects and opportunities that enhance shareholder value.
However, because the amount of capital available at any given time for new projects is limited,
management needs to use capital budgeting techniques to determine which projects will yield the
most return over an applicable period of time. Various methods of capital budgeting can include
throughput analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow
(DCF) and payback period.

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