Internal rate of return (IRR)
[Lorenzo Incarnato]
Contents |
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. Starting from the Net Present Value's formula, the discount rate that makes the Net Present Value of costs (negative cash flows) equal to the Net Present Value of benefits (positive cash flows) of that investment in a discounted cash flow analysis is called Internal Rate of Return. 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 and the net present value are commonly used together in an investment analysis because the two methods are strictly related. In fact, the formula for calculating the NPV is the same as the IRR but the unknown is different. The Internal Rate of Return method offers decision criteria to understand which project among multiple ones should be undertaken, and his utility increase when used in conjunction with other methods. In general, the higher the Internal Rate of Return of a project, the more desirable the investment to be made.
This article provides information on the importance of the internal rate of return in investment decisions, starting with understanding the discount rate, showing the formula and examples of real projects where IRR has been used, and ending with its limits.
While the first method gives information about the actual benefit or loss, in terms of money, that the investment will generate in the horizontal period according to the discount rate and, hence, if the discount rate changes, will change even the Net Present Value result. The second method provides information on the percentage rate such that the NPV is equal to zero. This information enables the company to quickly decide whether invest in the project or not.
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