TIR INTERNAL RATE OF RETURN OF A NEW COMPANY

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IRR stands for Internal Rate of Return and is a measure used to assess the profitability of an investment project. The IRR is the interest rate at which the net present value (NPV) of an investment project equals zero. In other words, it is the rate at which the cash flow of an investment project equals its initial cost. To determine whether a project is profitable, its IRR is compared with the discount rate being used for the project. If the IRR is higher than the discount rate, then the project is profitable. It is important to note that the IRR does not take into account the absolute size of the project, but its relative profitability. In addition, there may be multiple IRRs for a complex investment project, which can make it difficult to assess its profitability.

What is the difference between IRR and ROI (see+)?

The IRR is the The rate of return that makes the present value of an investment's future cash flows equal to its initial cost. It is a measure of the profitability of an investment over time, and the higher the IRR, the higher the return, therefore, takes into account the time period and that cash flow obtained many years from now is less valuable today. ROI, on the other hand, measures the effectiveness of the investment by comparing the benefit generated by the investment with the cost of the investment. It is expressed as a percentage, and the higher the ROI, the greater the effectiveness of the investment. In a nutshell, While IRR focuses on profitability over time, ROI focuses on the effectiveness of the investment in terms of benefit and cost. Both measures are important in the evaluation of investment projects, and are used in a complementary way to provide a complete picture of the profitability and effectiveness of the investment.

How is the IRR calculated for a new venture investment?

IRR (internal rate of return) is a measure used to assess the profitability of an investment. In the case of a new venture, the IRR can be calculated using the projected free cash flow and the cost of the investment. Calculating the IRR involves finding the discount rate that makes the net present value (NPV) of the future cash flows of the investment equal to zero. NPV is the present value of future cash flows at a given discount rate. If the IRR is higher than the required discount rate for the investment, then the investment is profitable.

An example of an IRR calculation for a new company would be as follows:

Assume that an initial investment of $100,000 is required to launch a new venture. The company is expected to generate free cash flows of $30,000 in the first year, $50,000 in the second year and $80,000 in the third year. The required discount rate for the investment is 10%.

• The present value of each future cash flow is calculated using the 10% discount rate:
  • PV year 1 = 30,000 / (1 + 0.10) ^ 1 = 27,273
  • PV year 2 = 50,000 / (1 + 0.10) ^ 2 = 41,322
  • PV year 3 = 80,000 / (1 + 0.10) ^ 3 = 59,873
• NPV is calculated by summing the present values of the cash flows:
  • NPV = -100,000 + 27,273 + 41,322 + 59,873 = 28,468
• A trial and error method is used to find the discount rate that makes the NPV equal to zero:
  • Suppose we try a discount rate of 20%:
    • PV year 1 = 30,000 / (1 + 0.20) ^ 1 = 25,000
    • PV year 2 = 50,000 / (1 + 0.20) ^ 2 = 34,722
    • PV year 3 = 80,000 / (1 + 0.20) ^ 3 = 47,862
    • NPV = -100,000 + 25,000 + 34,722 + 47,862 = 7,584
  • The IRR is somewhere between 10% and 20%, so further testing is done until the rate is found that makes the NPV equal to zero.

In this example, the IRR is found to be 18.5%, which indicates that the investment is profitable as it is higher than the required discount rate of 10%.

Practical examples of IRR calculation

Of course, here are two practical examples of how to calculate IRR:

EXAMPLE 1:

Suppose we want to invest in a new company and we are presented with the following situation:

• Initial investment: 100,000 euros
• Annual cash flow for 5 years: 30.000, 40.000, 50.000, 60.000 and 70.000 euros
• Discount rate: 10%

To calculate the IRR, we can use the internal rate of return formula in Excel:

=TIR(cash flow values, discount rate)

In this case, it would be:

=TIR(-100000, 30000, 40000, 40000, 50000, 60000, 70000, 0.1)

The result is an IRR of 20.45%.

EXAMPLE 2:

Suppose we want to invest in another new company and we are presented with the following situation:

• Initial investment: 200,000 euros
• Annual cash flow for 5 years: -40,000, 60,000, 80,000, 100,000 and 120,000 euros.
• Discount rate: 12%

To calculate the IRR, we can use the same formula for the internal rate of return in Excel:

=TIR(cash flow values, discount rate)

In this case, it would be:

=TIR(-200000, -40000, 60000, 80000, 80000, 100000, 120000, 0.12)

The result is an IRR of 22.08%.

It is important to note that, as with any other financial calculation, the IRR is only one tool to assess the profitability of an investment and should be used in conjunction with other metrics and analysis to make informed decisions.