Internal rate of return (IRR)

[Lorenzo Incarnato]

Abstract [13/02 ! ]

The Internal Rate of Return (IRR) is a key component of capital budgeting and corporate finance for estimating and evaluating the profitability of potential investments. It is defined as the rate of return (%) that makes the Net Present Value of costs (negative cash flows) equal to the Net Present Value of benefits (positive cash flows) of the investment in a discounted cash flow analysis. In other words, the IRR is the annual rate of return that an investment is expected to generate. This method 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 as in the case in calculating the NPV.

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Time value of money

In finance, the IRR is the discount rate or cost of capital of the firm, which causes the present value of the project's incoming cash flows to be equal to the initial investment. In other words, the IRR is an estimate of the project's rate of return.