Energy Affordability - Internal Rate of Return

IRR Equation, Calculation, and Usefulness

Contents

1. Introduction

2. What Is IRR?

3. Example Calculation

4. NPV and IRR

5. Concluding Remarks

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Bitesize Edition

• The next affordability metric I’m going to explore is the internal rate of return. The metric is calculated by setting the net present value of a project equal to zero and rearranging the equation to calculate the discount rate.

• This discount rate then refers to the internal rate of return on the project, which at an NPV of zero, will generate no discounted cash flows in the life cycle of the project.

• When considering IRR and the cost of capital, we can determine which projects will better handle tougher financing conditions. This is especially useful in the last few years when we’ve seen interest rate hiking cycles around the world. When coupled with NPV, we can utilise a worst-case scenario analysis, and projects that look favourable to both IRR and NPV could be projects that are pursued.

• So, let’s explore what IRR is, how it can be used, and any potential drawbacks of the metric.

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Introduction

As I continue to examine affordability metrics to analyse our energy projects, I today venture into the internal rate of return. How does IRR compare to net present value? And what is IRR? Find out below.

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What Is IRR?

The internal rate of return is the discount rate that would need to be applied to a project for the net present value to be equal to zero in a discounted cash flow statement.

Like most of these definitions of affordability metrics, there are multiple aspects to break down.

Firstly, the discount rate is the percentage rate used to calculate the present value of future cash flows. Due to inflation, £1 today is worth more than £1 next year. When forecasting cash inflows or outflows in the future, we hence have to account for the time value of money.

Net present value is what I’ve discussed over the last two weeks, and the articles can be found below:

I’d recommend reading these pieces first, at least the introduction to what NPV is, and then return here. A NPV of zero indicates that the cash flows generated over a project when discounted using the discount rate are equal to the initial investment in the project. In other words, the investment neither gains nor loses value and earns a rate of return equal to the discount rate in this scenario.

The final part of the definition refers to a discounted cash flow statement. This is the method used to estimate an investment’s value based on these future cash flows.

I’ve always been mathematically minded, and reading definitions has usually never allowed concepts to sink into my brain. With that in mind, let’s dive into an example calculation.

Photo by Igor Omilaev on Unsplash