Internal rate of return (IRR)
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The '''Internal Rate of Return (IRR)''' is a discounted cash flow method used in [[Wikipedia: capital budgeting |capital budgeting]] and [[Wikipedia: corporate finance |corporate finance]] for estimating and evaluating the profitability of potential investments. Starting from the [[Wikipedia: Net present value |Net present value]]'s formula, the discount rate that makes the present value of costs (negative cash flows)of an investment equal to the present value of benefits (positive cash flows) in a discounted cash flow analysis is called Internal Rate of Return. In other words, the IRR is the discount giving a net present value of zero when applied to the expected cash flow of a project. This rate of return is called "internal" because the formula provides a rate that depends only on the project, more precisely on the cash flows of the project, and does not depend on external factors such as market interest rates. | The '''Internal Rate of Return (IRR)''' is a discounted cash flow method used in [[Wikipedia: capital budgeting |capital budgeting]] and [[Wikipedia: corporate finance |corporate finance]] for estimating and evaluating the profitability of potential investments. Starting from the [[Wikipedia: Net present value |Net present value]]'s formula, the discount rate that makes the present value of costs (negative cash flows)of an investment equal to the present value of benefits (positive cash flows) in a discounted cash flow analysis is called Internal Rate of Return. In other words, the IRR is the discount giving a net present value of zero when applied to the expected cash flow of a project. This rate of return is called "internal" because the formula provides a rate that depends only on the project, more precisely on the cash flows of the project, and does not depend on external factors such as market interest rates. | ||
| − | In order to understand which project among multiple ones should be undertaken by the company the IRR offers a decision-criteria method, and it becomes more useful when used in conjunction with other investment analysis methods such as the NPV method. The IRR derives from the NPV as the formula is the same but the unknown is different and the unit of measurement is also different: the IRR method returns the rate return that the project is expected to generate over the time horizon, the NPV method instead determines the discounted monetary value that the project is expected to produce. Because of their relation, IRR and NPV are commonly used together to analyze the profitability of a project. In general, the higher the Internal Rate of Return of a project, the more desirable the investment to be made. | + | In order to understand which project among multiple ones should be undertaken by the company, the IRR offers a decision-criteria method that allows management to understand the profitability of multiple projects with a single calculation, and it becomes more useful when used in conjunction with other investment analysis methods such as the NPV method. The IRR derives from the NPV as the formula is the same but the unknown is different and the unit of measurement is also different: the IRR method returns the rate return that the project is expected to generate over the time horizon, the NPV method instead determines the discounted monetary value that the project is expected to produce. Because of their relation, IRR and NPV are commonly used together to analyze the profitability of a project. In general, the higher the Internal Rate of Return of a project, the more desirable the investment to be made. |
Revision as of 18:29, 12 February 2022
[Lorenzo Incarnato s220426]
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Contents |
Abstract
The Internal Rate of Return (IRR) is a discounted cash flow method used in capital budgeting and corporate finance for estimating and evaluating the profitability of potential investments. Starting from the Net present value's formula, the discount rate that makes the present value of costs (negative cash flows)of an investment equal to the present value of benefits (positive cash flows) in a discounted cash flow analysis is called Internal Rate of Return. In other words, the IRR is the discount giving a net present value of zero when applied to the expected cash flow of a project. This rate of return is called "internal" because the formula provides a rate that depends only on the project, more precisely on the cash flows of the project, and does not depend on external factors such as market interest rates.
In order to understand which project among multiple ones should be undertaken by the company, the IRR offers a decision-criteria method that allows management to understand the profitability of multiple projects with a single calculation, and it becomes more useful when used in conjunction with other investment analysis methods such as the NPV method. The IRR derives from the NPV as the formula is the same but the unknown is different and the unit of measurement is also different: the IRR method returns the rate return that the project is expected to generate over the time horizon, the NPV method instead determines the discounted monetary value that the project is expected to produce. Because of their relation, IRR and NPV are commonly used together to analyze the profitability of a project. In general, the higher the Internal Rate of Return of a project, the more desirable the investment to be made.
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Time value of money
IRR: definition and formula
Decision criteria
IRR in practice
Internal Rate of Return (IRR) vs Return on Investment (ROI) vs Net Present Value (NPV)
Draft: IRR vs VAN
While the first method provides information on the actual benefit or loss, in terms of money, that the investment will generate in the horizontal period based on the discount rate and, therefore, if the discount rate changes, the result of the Present Value will also be modified. The second method provides information on the percentage rate such that the NPV is zero. This information allows the company to quickly decide whether to invest in the project or not .........
