See: Internal Rate of Return - IRR.
Companies use a figure called internal rate of return to determine which projects to pursue. It measures the amount a given investment (like a new product or a new store opening) will generate the most future profit relative to the amount of money invested. Given a choice between a few opportunities, companies (and people too, for that matter) should pick the one with the biggest IRR.
IRR can be a little simplistic though. It's like reading the plot summary on Wikipedia versus actually watching a movie. You might not get all the subtleties (or subtitles).
Modified internal rate of return provides a more nuanced picture. Specifically, the MIRR takes into account what happens to the cash flow generated by the project. It works kind of like compound interest...a form of calculation that takes the simple equation a step further by contemplating what happens to all that extra interest earnings.
With a usual IRR calculation, the money generated from a project just kind of floats away into the ether. The math doesn't consider those funds. MIRR, on the other hand, assumes that this cash gets invested back into the project.
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Finance: What is IRR?5 Views
Finance Allah Shmoop what is I r r This is
an ear And nope it has nothing to do with
ai r r Instead I r r stands for internal
rate of return Yeah All right So what does that
mean While internal rate of return sounds like something medical
right Like something in the neighborhood of colonoscopies and other
loving invasions by the dock Well you know what a
return is on an investment You invest a dollar and
I'll say it returns ten percent a year for seven
years and changed seven point two years for the rule
of seventy two While then it'll double I R r
refers to the growth rate of capital invested in a
given project Usually as it relates to a company's allocation
of their precious cash resource is to invest for growth
in themselves in the future I r is just about
the compound rate of return and investor And that investor
can be your company investing in an internal project that
that investor needs to receive in order for the dough
to be worth spending in the first place Think about
it like a financial hurdle You have to jump over
the difficult part of an IRA Our calculation revolves around
some notional percent return that you have to have in
order for that project to be you know worth doing
Like why do you need a ten percent return versus
a fifteen percent Why not twenty or thirty Well when
you do your cash invested and cash return calculations are
you considering the hidden values in doing this deal Like
investing in the IMU set You know who produced colored
eggs in hopes of igniting a new Easter fad that
enhances the brand value of your IMU Meet whether it
works or not Vegans aside like who wouldn't want blue
pink and green IMU meat So there's kind of an
echo effect in surfacing hidden benefits that aren't necessarily part
of the cash on cash Return calculations When companies make
those ire our calculations for investing their precious cash well
The hurdle rate element that companies use in Iraq calculations
is kind of arbitrary but the discipline is good and
pretty simple If you're investing two hundred fifty million dollars
in a new battery plant for your drones well then
you'd better get a lot more than two hundred fifty
million dollars of value back from it Right So go
back to our favorite rule of seventy two thinking here
if you needed a twelve percent return Well it would
say that the value of your two hundred fifty million
dollars has to be worth at least five hundred million
dollars to you six years later And there are likely
foundational frames around meeting that twelve percent number Like in
real life if you're a financial manager in a big
fat company you're going tohave competition That is you'll have
other players who want to invest money in their projects
over yours Like you have a drone painting a project
and you have a drone management in a drone life
insurance products and all those people want the company's cash
to build their product over yours or their project anyway
So you'll have to demonstrate on paper to your boss's
boss's boss that your project has ah higher I r
r than theirs And if you're good you'll cover the
hidden risks and strategic values as part of your pitch
Okay here's the math So what was our IRA and
the project We just outlined the battery plant Well we
laid out two hundred fifty million bucks and we get
back a lot like multiples of two hundred fifty million
dollars There are a bunch of ways to think about
IRA but let's figure out the years it takes to
well first double our money and we can then get
to the rate of return with our handy dandy rule
of seventy two We've got back all our money in
about three years but the gifts keep on giving It's
not like the battery plant is useless after three years
right Like it's saved us a lot of one hundred
forty million in year one and then eighty and year
to and then maybe on seventy eighty fifty some number
in your three So we've gotten all two hundred fifty
million dollars of value back in just three years and
the battery plant is still functioning In fact it should
keep dividend ing batteries for decades And with the plant
fully paid off in just three years well everything else
it gives back is pretty much gravy lots and lots
of creamy electrified gravy It's a hundred fifty mil back
to us after three years and then things continue like
Let's say in year four we get one hundred ten
million dollars of battery value and then one twenty in
year five one thirty in Year six or something like
that Adam all up and well even with our discount
rate like valuing them for today's dollars one point one
two to the six powers how we divide back that
hundred thirty million years Six And that's how we do
it That's what it looks like So how long can
this battery plant last Maybe twenty years And what about
the side door business of selling our battery capacity to
others Well if we did that then wow we could
make two hundred million dollars a year or more from
this plant And this doesn't even count the strategic value
of likely having bankrupted our would be editors who sell
an inferior product for almost twice the price So what
if we wanted to just then sell the battery plant
in some number of years Then it might go for
a billion dollars or more so than what the cash
flows look like in our hierarchy Talc Well you got
whatever the first three years where we got all our
money back and change and then a few more years
of milking and then a few more years after that
Then we sold it for a billion dollars in your
ten or something like that But regardless in this case
this is a spectacularly good project We generated almost half
a billion bucks let's say in cash along the way
and then sold the whole plan for over a billion
dollars At the end We'll the key element you have
to grow up with Regard to IRA is that the
return has to be positive for a project to be
green lit positive meaning higher than the hurdle rate That
is if you take into account the cost and opportunity
cost of the capital you're deploying the risk adjusted net
present value in the strategic hidden elements will then IRA
has to be a positive dollar amount worth doing In
this case we started with that twelve percent per year
comp on return figure as our minimum bass case to
deem a project worthy of green lighting So the new
opportunity looked a delicious WE green lit it and well
if all goes well you'll be a swimming in colored 00:05:42.521 --> [endTime] IMU meat