Internal Rate of Return (IRR)
Developed by Pablo Leandro Capellari- s213666
Internal rate of return (IRR) is a parameter used in the financial analysis to determine the profitability of the investment, that is, it estimates the rate of return that the evaluated project could have. The term "internal" is due to the fact that for the calculation of the IRR, external factors that could affect the profitability of the project, such as inflation, are not considered. In mathematical terms, the IRR is defined as the discount rate that causes the sum of the cash flows of the project to be zero[1]. In other words, if the net present value (NPV) of a project is 0 at a certain rate, that rate is the IRR[2]. Researchers in 2003[3] have validated the IRR as an alternative to the NPV as an indicator for project evaluation, considering that the IRR as from the point of view of the investor and the NPV from the point of view of the society. Its popular application is mainly because it defines the return on investment, sometimes seen as a measure of efficiency, beyond its documented limitations. For decision-makers, the IRR can be compared to the discount rate for rejecting or accepting projects. To be specific, for a project to be accepted, the IRR must be greater than the discount rate and when both are equivalent, a situation of indifference arises[1]. To resolve many deficiencies related to the traditional IRR, some researchers[4] have proposed to use the average internal rate of return (AIRR). The AIRR is based on the breakdown of the NPV of the project between the invested capital and the economic efficiency, maintaining the consistency of the NPV to decide the acceptance of a project. This breakdown generates valuable information helping to determine the uncertainty of a project allowing risk to be explored in more detail.
Contents |
Big idea
Describe the tool, concept or theory and explain its purpose. The section should reflect the current state of the art on the topic
Application
Provide guidance on how to use the tool, concept or theory and when it is applicable
Limitations
Critically reflect on the tool/concept/theory. When possible, substantiate your claims with literature
Annotated Bibliography
- ↑ 1.0 1.1 Hartman, Joseph C., and Ingrid C. Schafrick. «THE RELEVANT INTERNAL RATE OF RETURN». The Engineering Economist, Vol. 49, no. 2, January 2004, p. 139-58. DOI.org (Crossref), https://doi.org/10.1080/00137910490453419.
- ↑ Patrick, Michael, and Nick French. «The internal rate of return (IRR): projections, benchmarks and pitfalls». Journal of Property Investment & Finance, vol. 34, no. 6, January 2016, p. 664-69. Emerald Insight, https://doi.org/10.1108/JPIF-07-2016-0059.
- ↑ Tang, S.L., and H. John Tang. «TECHNICAL NOTE: THE VARIABLE FINANCIAL INDICATOR IRR AND THE CONSTANT ECONOMIC INDICATOR NPV». The Engineering Economist, Vol. 48, no. 1, January 2003, p. 69-78. DOI.org (Crossref), https://doi.org/10.1080/00137910308965052.
- ↑ Hazen, Gordon, and Carlo Alberto Magni. «Average Internal Rate of Return for Risky Projects». The Engineering Economist, Vol. 66, no. 2, April 2021, p. 90-120. DOI.org (Crossref), https://doi.org/10.1080/0013791X.2021.1894284.
