IRR Rule

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