Internal rate of return (IRR)

[Lorenzo Incarnato s220426]

- references - pictures

Abstract

The Internal Rate of Return (IRR) is a powerful discounted cash flow method used in capital budgeting and corporate finance to estimate and evaluate the profitability of potential investments. Keep in mind the calculation for the Net present value, the IRR is defined as the discount rate that makes the present value of the costs (negative cash flows) of an investment equal to the present value of the benefits (positive cash flows). In other words, the IRR is the discount rate that gives a net present value of zero when applied to the expected cash flow of a project. This rate of return is called internal because the formula predicts a rate that depends only on the project, more precisely on the project's cash flows, and does not depend on external factors such as market interest rates or inflaction . One of the main advantages in using the IRR method to evaluate an investment, compared to others such as the Payback period or the Benefit-cost ratio is that IRR reflects the time value of money . This article shows also the limitations of the internal rate of return, however, when the IRR is unique, it provides relevant information about the return on investment and is also used as a measure of investment efficiency. In fact, according to academic research, three-quarters of Chief Financial Officer use the IRR method to evaluate capital projects .

To understand which project among the different projects the company should undertake, the IRR offers a method of decision criteria that allows management to have an overview of the profitability of multiple investments with a single calculation. - The net present value method determines the discounted monetary value ($) that the project should produce considering a fixed discount rate. It means that for more rates you will have more net present values. The internal rate of return is that particular rate for which NPV = 0. - This information combined with the relationship between NPV and the discount rate allows management to undertake the most profitable project among multiple projects. In general, as analyzed below, the higher the Internal Rate of Return of a project, the more desirable the investment to be made.

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 .........