Intuitive Definition of IRR
Can someone please give me an intuitive definition of IRR?
I know that it's the discount rate used to find the break-even point on a project, or the discount rate used to get an NPV of 0. However, what I'm having a hard time grasping is why you choose the project with the higher IRR?
If it's the rate required to break-even, wouldn't you want it to be as low as possible, so that profitability would be easier?
Thanks in advance.
Relate it back to DCF where the discount rate is WACC, if your IRR rate is larger than WACC this means the cash flows are of enough value to pay those cost, WACC, with excess value.
This cost, a discount rate, is a measure of uncertainty, TVM exists because people require compensation for the uncertainty of money later rather than now. Then as a market interest rate or discount rate, it is the cost required to compensate for not just time, but risk of repayment. so to an IRR is the total risk and uncertainty a project can exhibit while still being economic to actioned, so when that is > than your WACC you've got economic benefit
does that help?
I think you are getting confused on how to interpret the IRR.
You want your discount rate to be low, so profitability is easier.
You are reducing your future cash inflows with a discount rate due to the time value of money. The lower the discount rate is, the less your future inflows get reduced, the higher your NPV is.
Your IRR tells you what discount rate makes NPV 0. Since we generally think of our discount rate as our cost of capital - the firm's cost of financing these projects - if we have a higher IRR than our discount rate, that means we have some wiggle room in terms of our cost to finance the project.
The greater the gap between the two, the more wiggle room we have. Our future outflows could be smaller and our project would still have a positive NPV/increase firm value. Our financing costs could increase due to macro conditions and the project would still be successful. Does that make sense?
Ahh that's right. Thanks a lot guys, I was thinking IRR and WACC were virtually the same thing...I'm retarded. Appreciate the help though!
The most intuitive way to think about IRR is to remember it is just a compound growth rate. That's it. If your IRR is 15%, then that means your money is growing at 15% per year.
This is only true when interim cash flow payments (if there are any) are reinvested at the same rate. If not, then you're actually growing at less than 15%.
At the end of the day IRR is pretty pointless b/c of the reinvestment assumption right? A modified IRR would be the only one that might make sense, but even then, how are you supposed to know the rate at which you can reinvest cash flows? and how to do even calculate that reinvestment rate?
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