IRR - NPV 0, why is this good? Confused
hey guys,
would appreciate some of your insights on IRR. from what i understand, IRR is the discount rate at which the NPV of the project is 0.
I understand PE firms like to see 20%+ IRR. I seem to be confused as to the point of calculating IRR if IRR just means the NPV is 0. Isn't that a bad thing?
for example, a 25% IRR would be considered strong, but it just means that NPV is 0. this is good?
sorry if this is a rather dumb question... very little finance/accounting background.
thanks!
You are conflating two different concepts. IRR represents the underlying cash yield of the investment, which may differ from the cost of capital of the investor. If IRR>cost of capital, then the project creates value. Typically an NPV is calculated using the cost of capital or required rate of return (not the IRR), so NPV would be positive so long as the discount rate is lower than IRR / underlying cash yield of the investment.
Thank you! So helpful.
How then is IRR equated with the discount rate? I've heard several people essentially say that IRR is the discount rate. That really seems to trip me up
From a WACC perspective, IRR is essentially the return on equity.
Just to add on to @diverse_kanga's point - IRR =/= CoC.
When you set NPV = 0, you're essentially equating cash flow yield with its associated costs. By doing this, you essentially see what the highest possible cost of capital would be for the project to just break-even. You can then compare this number with a hurdle rate or CoC to see if the investment is worthwhile; if IRR > CoC, then that means the project creates value.
Thx so much. very helpful. posted a follow up question above, replying to diverse_kanga
IRR is a discount rate that makes the NPV of all cash flows equal to zero... WHAT?
In layman's term IRR is telling us what our average return is when time value of money is factored in. The time value of money is the key piece here.
Let's say I have an option to get 100K today or 100K in 5 years. Although I would still gladly accept 100K 5 years from now, I would obviously prefer to get paid today so I can reinvest and also prevent future inflation from eating my purchasing power.
An investment that realizes returns sooner than later will have a higher IRR. Scenario 1 and 4 returns same cash flows in terms of $$ but due to the timing, one have an IRR of ~21% and the other ~49%.
Dates are in grey where they dont matter (not part of the formula)
In excel you always wanna stick with XIRR to account for time periods that may be out of place rather than IRR which assumes equal time periods between cash flows (dates, week. months, years, etc.)
What you are referring to is the budgeting rule (from my memory of college corp. finance textbooks) i.e. you determine the IRR at which NPV is zero and then compare with the IRR of your project. Whoever is at college right now can correct me.
In the world of PEs and LBOs, IRR is the return you will receive:
(1) based on the money you will spend to acquire a target company and (2) projected dividends from said company or exit proceeds from the eventual sale
Just to clarify - IRR in itself is really just a discount rate that we use to discount cash flows. What I listed above are two ways it is used: (1) in budgeting and (2) in LBOs
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