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What is the 'IRR Rule'

The IRR rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.

BREAKING DOWN 'IRR Rule'

The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. The IRR rule is used to evaluate projects in capital budgeting, but it may not always be rigidly enforced. For example, a company may prefer a project with a lower IRR over one with a higher IRR because the former provides other intangible benefits, such as being part of a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.

Example Internal Rate or Return Rule Decision

Assume there are two projects that a company is reviewing. Management must decide whether to move forward with one, none or both of the projects. The cash flow patterns for each project are as follows:

Project A

Initial Outlay = $5,000

Year one = $1,700

Year two = $1,900

Year three = $1,600

Year four = $1,500

Year five = $700

Project B

Initial Outlay = $2,000

Year one = $400

Year two = $700

Year three = $500

Year four = $400

Year five = $300

The IRR for each project must be calculated. This is through an iterative process, solving for IRR in the following equation:

$0 = (initial outlay x -1) + CF1 / (1 + IRR) ^ 1 + CF2 / (1 + IRR) ^ 2 + ... + CFX / (1 + IRR) ^ X

Using the above examples, the IRR for each project is calculated as:

IRR Project A: $0 = (-$5,000) + $1,700 / (1 + IRR) ^ 1 + $1,900 / (1 + IRR) ^ 2 + $1,600 / (1 + IRR) ^ 3 + $1,500 / (1 + IRR) ^ 4 + $700 / (1 + IRR) ^ 5

IRR Project B: $0 = (-$2,000) + $400 / (1 + IRR) ^ 1 + $700 / (1 + IRR) ^ 2 + $500 / (1 + IRR) ^ 3 + $400 / (1 + IRR) ^ 4 + $300 / (1 + IRR) ^ 5

IRR Project A = 16.61%

IRR Project B = 5.23%

If the company's cost of capital is 10%, management should proceed with Project A and reject Project B.

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