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How do you use IRR to rank and select mutually exclusive projects?

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Capital budgeting is the process of evaluating and selecting long-term investments that maximize the value of a business. One of the tools that can help you compare and choose among different projects is the internal rate of return (IRR). But how do you use IRR to rank and select mutually exclusive projects? In this article, you will learn what IRR is, how to calculate it, and how to apply it to different scenarios.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of…

1 What is IRR?

IRR is the discount rate that makes the net present value (NPV) of a project's cash flows equal to zero. In other words, it is the annualized return that a project generates over its lifetime. The higher the IRR, the more profitable the project is. However, IRR does not consider the size, timing, or risk of the cash flows, so it should not be used alone to make capital budgeting decisions.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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IRR is said to be strongly associated with NPV. It is a single rate of return that encapsulates the potential earnings of a project. It is often used as the discount rate when the NPV is zero. Its stated rule is that if the IRR exceeds the require rate of return set by the company, the project should be accepted, otherwise rejected. It recognizes the time value of money.

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2 How to calculate IRR?

To calculate IRR, you need to estimate the cash flows of the project and then find the discount rate that makes the NPV equal to zero. You can use a trial-and-error method, a financial calculator, or a spreadsheet function to do this. For example, suppose you have a project that requires an initial investment of $10,000 and generates cash flows of $3,000, $4,000, $5,000, and $6,000 in the next four years. Using a spreadsheet function, you can find that the IRR is 23.44%.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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For a proposed project with even cash flows, the payback period is equal to the Initial Investment divide by the After-tax Annual Cash Flow. In contrast, for proposed project with uneven cash flows, you can either use the excel spreadsheet function on time value of money which is the "IRR()" function or the manual method by working backwards using the Present Value (PV) Annuity Table to estimate the IRR. Below is the formula for finding the Annuity Factor. Annuity Factor = Initial Investment / Annual Cash Flow After getting the annuity factor and given the investment period, then you should be able to find the IRR from the PV Annuity Table.

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3 How to rank projects by IRR?

If you have multiple independent projects, meaning that they do not affect each other, you can rank them by IRR and accept all the projects that have an IRR higher than your required rate of return or hurdle rate. For example, if your hurdle rate is 10%, you can accept any project that has an IRR above 10%. However, if you have mutually exclusive projects, meaning that you can only choose one among them, you need to be more careful.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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Its stated rule is that if the IRR exceeds the require rate of return set by the company, the project should be accepted, otherwise rejected.

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4 How to select projects by IRR?

If you have mutually exclusive projects, you cannot simply choose the one with the highest IRR, because it may not be the one with the highest NPV. This is because IRR assumes that the cash flows are reinvested at the same rate as the IRR, which may not be realistic. For example, suppose you have two projects, A and B, with the following cash flows:

Project A: -$10,000, $5,000, $5,000, $5,000

Project B: -$10,000, $0, $0, $20,000

The IRR of project A is 16.41%, while the IRR of project B is 14.87%. However, if your hurdle rate is 10%, the NPV of project A is $6,284, while the NPV of project B is $8,513. Therefore, project B is more valuable than project A, even though it has a lower IRR.

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5 How to solve the IRR problem?

One way to solve the problem of choosing mutually exclusive projects by IRR is to use the incremental IRR. This is the IRR of the difference between the cash flows of the two projects. For example, the incremental IRR of project B minus project A is 12.22%. This means that project B is better than project A if your hurdle rate is lower than 12.22%, and vice versa. Another way to solve the problem is to use the modified IRR (MIRR). This is the IRR that assumes that the cash flows are reinvested at your hurdle rate, rather than at the IRR. For example, the MIRR of project A is 13.86%, while the MIRR of project B is 14.87%. Therefore, project B is better than project A by both NPV and MIRR.

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6 How to use IRR effectively?

When using Internal Rate of Return (IRR) for capital budgeting, it is important to be aware of the limitations and assumptions associated with the tool. To ensure you are using IRR effectively, you should estimate the cash flows of the projects as accurately as possible, use a realistic and consistent hurdle rate for your projects, compare IRR with Net Present Value (NPV) and other criteria such as payback period or profitability index, use incremental IRR or Modified Internal Rate of Return (MIRR) for mutually exclusive projects, and avoid projects with multiple or negative IRRs. Following these guidelines will help you rank and select mutually exclusive projects that add value to your business.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you use IRR to rank and select mutually exclusive projects?

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1 What is IRR?

2 How to calculate IRR?

3 How to rank projects by IRR?

4 How to select projects by IRR?

5 How to solve the IRR problem?

6 How to use IRR effectively?

7 Here’s what else to consider

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