Glossary · Finance
Internal rate of return (IRR)
The discount rate at which the net present value of a series of cash flows is zero. It can mislead where cash flows change sign more than once or projects differ in scale.
- Field
- Finance
- Examined in
- CBA-FMA
- Learning objectives
- 1
Where the CBA Standards examine it
In the specimen paper
Dunraven Minerals is appraising a quarry with cash flows of -£100m today, +£250m at the end of year 1 and -£156m of restoration costs at the end of year 2. The spreadsheet IRR function returns 20% with its default guess, while a colleague using a guess of 0.35 obtains 30%. The WACC is 12%. How should the team interpret these results?
Answer
Both 20% and 30% solve the equation, so the decision should rest on the NPV at the 12% WACC.
Why that is the answer
An IRR is a root of the NPV equation, so the number of possible answers follows the number of sign changes in the cash flow sequence. Here the flows go negative, positive, negative, which admits up to two roots, and both 20 per cent and 30 per cent set the NPV to zero exactly. Once the rate is not unique, comparing it with the WACC is meaningless, because a rate that satisfies the equation twice cannot rank the project against a hurdle. NPV at the firm's cost of capital always returns one answer, which is why decommissioning, restoration and staged reinvestment profiles should be appraised on NPV as a matter of routine rather than only when someone notices a second root.
Related terms
- Net present value (NPV)Finance
The sum of the present values of a project’s expected cash flows, including the initial investment. A positive NPV indicates value created at the chosen discount rate.