Internal rate of return (IRR)
[Lorenzo Incarnato]
Contents |
Abstract
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 IRR derives from the NPV as the formula is the same but the unknown is different and the unit of measurement is also different, monetary for NPV and percentage for IRR. Because of their relation, they are commonly used together to analyze the profitability of a project. The Internal Rate of Return method offers a decision-criteria to understand which project among multiple ones should be undertaken by the company, and it becomes more useful when used in conjunction with other investment analysis 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 Internal Rate of Return method, explaining its importance in investment decisions, showing the formula and examples of real projects where IRR has been used, and ending with its limitations and possible solutions.
[254 words]
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.
