A blonde wanting to earn some money decided to hire herself out as a handyman-type and started canvassing a wealthy neighbourhood.

She went to the front door of the first house and asked the owner if he had any jobs for her to do. “Well, you can paint my porch, how much will you charge?” he replied.

The blonde said, “How about $50.00 ?”

The man agreed and told her that the paint and ladder were in the garage. The man’s wife, who was inside the house, heard the conversation and said to her husband, “Does she realise that the porch goes all the way around the house?”

The man replied, “She should, she was standing on the porch.”

A short time later, the blonde came to the door to collect her money. “You’re finished already?” he asked.

“Yes”, the blonde answered, “and I had paint left over, so I gave it two coats.”

Impressed, the man reached in his pocket for the $50.00. “And by the way,” the blonde added — taking the money, “that’s not a Porsche; it’s a Ferrari.”

~ (www.slightlywarped.com/jokes/jokes/blonde_porch_painter.htm)

No offence to blondes (or to anybody else!), but this just shows that some investments have serious negative returns! On another note — one of these days the MBA Forum will be looking at the intricacies and importance of communication.

Before

the holidays we had started looking at Capital Budgeting and we reviewed Payback and Net Present Value. You may review that article, published on December 20, 2015. Today we will review the Internal Rate of Return. If you really want to understand IRR please follow me as I use some numbers to explain. Don’t be intimidated — I will use only very simple numbers!

Internal Rate of Return (IRR)

Based on how we teach and also how some definitions are coined in textbooks, many times a fairly simple concept is rendered difficult to understand. Take for example the Internal Rate of Return (IRR), a popular tool used in Capital Budgeting activities; textbooks generally define it as “the discount rate that equates the present value of the expected cash outflows with the present value of the expected inflows.” (

Financial Management & Policy — James Van Horne) .

Very simply, the IRR is really the rate of return that is earned on an investment. The only issue that also needs to be understood is that the time value of money has to be factored in. That is why I love the definition given by Schmidt in the blog at www.propertymetrics.com/blog/2014/06/09/what-is-irr/ : “the percentage rate earned on each dollar invested for each period it is invested.” My own personal definition of IRR actually uses its own terms: It is the internal or intrinsic rate of return for a period of time based on an investment and the returns on that investment.

IRR Examples

Let us use a couple of examples to show you how simple the IRR concept is. If you invested $100 and at the end of one year you recouped a total of $115 then the IRR would be 15%. Simple — right?

Now that you get the hang of it — suppose instead you invested the $100 and at the end of year one you received nothing, but at the end of year two you received $130. What would be the IRR?

If you answered 30% per cent you would be wrong. If you thought it was 15% per cent you would be warm (you know — “how warm you are, …”) but still wrong. For the answer to have been 15 per cent, look at this: — If you invested $100 at 15% at the end of year one you would have $115. If you re-invested the $115 at the end of year one for one more year at the same 15% you would have $132.25 at the end of year two!

So let’s do it again. If you invested $100 and received nothing at the end of year one then received a total of $132.25 at the end of year two — then the IRR would be 15%. Got it?!

So how do you calculate it? Now that you understand the concept, all you need to do is understand how Microsoft Excel does it. Are you ready?

IRR on Microsoft Excel

We will use the same example we used above. Open Excel and enter -100 (that is negative 100) in cell A1, 0 (that is zero) in A2 and 132.25 in A3. In cell A4 enter =IRR(A1:A3) then press the Enter key. If you did everything right, then A4 should show you the 15 per cent which is the IRR as we had demonstrated before. If you want to see the IRR for the example with the $130 after year 2, then change A3 to 130. You will see the new IRR of 14 per cent. Neat — isn’t it?

Just to make sure you understand what we did. A1 contains the initial cash outflow of $100, and is shown as a negative number (for outflow). The 0 in A2 signified that there was no cash inflow or outflow at the end of year 1. That is necessary because Excel uses the order of the numbers to determine the period involved. Finally, A3 showed the cash inflow at the end of Year 2. A4 gives the IRR Excel function that actually does the calculation for you.

So for capital budgeting decisions, if all else remains equal, then pursuing the project with the highest IRR would be the best decision. So now you are an expert on IRR!

Dr Kenroy Wedderburn is an MBA part-time lecturer. Send your e-mails to drkwedderburn@gmail.com.