Simply, when evaluating investments, my company would not even consider a project unless it had 15% IRR and even at that IRR, it would have to be relatively risk free. They didn’t want to borrow money at the prime rate plus plus for a low return project. The higher the return of the IRR, the more risk the company was able to tolerate.
The NPV discount rate was the cost of borrowing money, usually the prime rate plus 1%.
So IRR is the hypothetical discount rate (calculated using projected future cash flows) that would make the NPV of a project equal zero?
And IRR is useful where the hypothetical discount rate is higher than the actual discount rate?
Ding ding ding. winner winner, chicken dinner!
It is usually useful when it is greater than or equal to some required rate of return established by the investor. That doesn’t mean it can be used on a stand alone basis. Many other factors are usually taken into consideration such as NPV.
Also, there is no “actual discount rate” in the sense that a certain rate is considered correct. One company might use a discount rate equal to their cost of borrowing. Another might use the weighted average cost of capital (“WACC”), and another might use some arbitrary number that sounds reasonable.
In real estate investments, IRR makes a good benchmark. Most of your investors are looking for their investments to pull down a certain IRR.
But you do find that in JV’s, your partners tend to want to sell out of properties early. That generates a high IRR so they get their incentive fees. But it doesn’t return much cash if you sell too early. You’re forever churning funds into new investments which is costly. So we also use an equity multiple to reach certain incentive thresholds.