Internal rate of return (IRR)

[Lorenzo Incarnato s220426]

- references - pictures

Abstract

This article provides information on the relevance of the internal rate of return method in project investment decisions, starting from the monetary value of time, showing the formula and examples of real projects where IRR has been used, and ending with its limitations and possible solutions.

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 NPV of costs (negative cash flows) equal to the NPV 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 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 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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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 .........