Internal rate of return for property development
Calculating the Internal Rate of Return (IRR) of a project is a widely used method of assessing a potential project’s viability.
It is a similar calculation to Net Present Value (NPV) and Discounted Cash Flow (DCF) in that anticipated future income and expenditure are used to assess whether or not to proceed with a project. The IRR is the percentage which, when applied to future capital costs and receipts, results in a Net Present Value of £Nil.
If project 1 has an IRR of 12% and project 2 an IRR of 8% then project 1 would be selected to proceed as it has a higher IRR.
Usually the project IRR must exceed the cost of capital by an agreed amount so that the risk of proceeding is seen to be within acceptable commercial parameters. It can be seen, therefore that an accurate cash flow projection for a prospective project must be developed before an accurate IRR assessment can be made.
Because the IRR is expressed as a percentage per annum it can be used to assess the Yield of a particular investment.
Most spreadsheet packages have an IRR function which, when applied to a project model cash flow, will calculate the IRR for you.
--Martinc
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