Describe how service projects can beevaluated using IRR. Explain how this approa
ID: 1249265 • Letter: D
Question
Describe how service projects can beevaluated using IRR. Explain how this approach relies on theeconomic concept of ‘opportunity cost’.
I'm a little confused on what IRRis, i know it is an interest rate and that you compare it to MARRto see if a project is worth it. But i don't see how it even applysto a service project because you don't get any revenue or profitfrom a service project.....
I WILL RATE LIFESAVER!!! If you can explain this to me. Please beas clear as you can, i'm not the brightest when it comes toeconomics....
Explanation / Answer
Internal Rate of Return (IRR) seems to befuddle many investors,but if you understand Discounted Cash Flow and Net Present Value,then you already understand IRR. That’s because it is reallythe same process, but one where you are solving for a differentunknown.
In DCF, you believe you know what the future cash flows will be,and you believe you know the rate at which those cash flows shouldbe discounted. Your mission is to figure the Present Value of thecash flows.
With IRR, you still believe you know what the future cash flowswill be, but now you know the Present Value and want to find thediscount rate. How is it that you know the Present Value? This is adeal happening in the real world. The PV is the amount of cash youare paying for those future cash flow. When you solve for the IRR,you are looking for the discount rate that accurately describes therelationship between those future cash flows and the money you puton the table on Day One.
When you’ve found the discount rate that makes the PVs ofthe future cash flow equal to your initial investment, you’vefound the IRR. You can express this another way: When you’vefound the discount rate that makes the NPV equal zero, you’vefound the IRR.
Admittedly, the math to find the IRR is ugly, but ifyou’re reading this then you probably have a computer (or ahighly sensitive gold filling that also picks up the BBC); thereare plenty of tools, including Microsoft Excel and our own RealDatasoftware that will do the job for you.
IRR is the measurement of choice for many investors because ittake into account both the timing and the magnitude of your cashflows. Consider this example:
You still have that $300,000 to invest, and you can invest it inthe property you saw in the first example, yielding these cashflows and IRR:
Or you can acquire this property:
If you add up the cash inflows and outflows for both properties,you will find that each has $300,000 going out in Year 0, and atotal of $470,000 coming in over the next five years. However, thesecond property shows a significantly higher IRR. Both propertieshave the same total number of dollars going out and coming in overfive years, but the second property shows a greater return oninvestment. Why?
Because IRR is indeed sensitive to both the timing and amount ofcash flow. The first property has a big payday, but you have towait five years to get the money. In the meantime, cash flows arerelatively modest. In the sale year the second property returnscombined cash from operation and resale that is only as much as youoriginally invested to acquire the property. However, theintervening cash flows are much larger, especially the earlierones. The early cash flows are especially valuable because youdidn’t have to wait long to receive them and therefore youdidn’t have to discount their values so greatly.
But Wait...
Year 0 Initial Investment: (300,000) Year 1 Cash Flow: 10,000 Year 2 Cash Flow: 20,000 Year 3 Cash Flow: 25,000 Year 4 Cash Flow: 30,000 Year 5 Cash Flow: 385,000 (includes the proceeds of sale) IRR = 10.32%