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Internal rate of return - Wikipedia, the free encyclopedia

In more specific terms, the IRR of an investment is the interest rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.

Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital.

Your Figure 26 is fascinating. Let me see if I read it right: to produce one barrel of oil outside the OPEC and still get a 12% IRR on it, you currently need to invest about 80 dollars. Correct?

Noob question: At what IRR becomes a financial undertaking no longer interesting? Is that at zero percent, or something in between twelve and zero?

by Nomad on Fri Feb 25th, 2011 at 07:37:00 AM EST
A project has a zero rate of return for an enterprise when the IRR is equal to the projected cost of funds over the term of the project.  Thus if the IRR for a project is 8%, but the enterprise can only borrow at 8%, then there is no point in proceeding from a return on investment point of view.

In practice, companies also factor in risk factors when evaluating projects - e.g. project cost over-run, project benefits under-delivery, or interest rate rises over the lifetime of the project and often set a minimum IRR rate (often 10%) or payback period as a matter of policy.

Projects are also generally evaluated within the context of an overall capital budget which is considered financially or strategically desirable for a company.  I.e. How leveraged does a company want to be?  Are there other projects with a better estimated IRR?  How strategic is the proposed investment?  How related is it to a company's core business?

I have seen some absolutely crap projects approved because they were sold as a good strategic fit by an influential director whilst many potentially good projects are passed up because the project sponsor hasn't managed to "clear his lines" with key players in the approval process.

In my experience project appraisal processes are often quite rigorous (except in marketing) whilst post completion reviews are often "swept under the carpet" where objectives were not met.

PS - you added "frontpaged by" to my Irish Election post - but it doesn't appear on the front page.  Do you want me to use that diary to live blog results as they come in tomorrow, or do you want to set up a separate open thread?

Index of Frank's Diaries

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 08:03:03 AM EST
[ Parent ]
Jerome's story got there first - so I put your diary back in the diaries for now, but yours will go back to the frontpage this afternoon.
by Nomad on Fri Feb 25th, 2011 at 08:15:19 AM EST
[ Parent ]
Thanks - I thought it might have been some scoop blip.  Every now and then the number of comments to a story is doubled and then it mysteriously goes back to the correct number.

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 11:21:16 AM EST
[ Parent ]
Frank is right.

The short answer is that you need to compare the IRR to the average Cost of capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
It is an average of the yield of the company's bonds and the implied return on its equity shares which should be higher than that of bonds but is harder to estimate (the yields on bonds is just a market quotation).

Keynesianism is intellectually hard, as evidenced by the inability of many trained economists to get it - Paul Krugman
by Migeru (migeru at eurotrib dot com) on Fri Feb 25th, 2011 at 08:19:28 AM EST
[ Parent ]
In my experience (outside the financial services sector, but within a large publicly quoted global enterprise) the benchmark was a standardised cost of funds derived from the cost of bank borrowings as investor funds were rarely sought for individual projects.  The latter really only applied when evaluating the cost benefit of a significant business acquisition or merger which might require raising funds directly from new investors or existing shareholders..

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 08:37:14 AM EST
[ Parent ]
Easy answer, as quoted to me by my first employer, when I asked for money to buy a new oscilloscope: "I have $4000 in my wallet. I can put that $4000 into the bank or I can give it to you. Show me why I should give it to you."
by asdf on Fri Feb 25th, 2011 at 09:37:53 AM EST
[ Parent ]
Most companies are financed partially by bank borrowings.  So the slightly more accurate formulation is:  I'm going to have to borrow more to fund your project.  Can you guarantee me your project will enable me to pay the bank back the capital and interest and also leave me with a tidy profit to justify the risks any project entails?

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 04:34:07 PM EST
[ Parent ]


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