Internal rate of return (IRR)
[Lorenzo Incarnato s220426]
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Contents |
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 inflation [1]. 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 [2]. In general, as analyzed below, the higher the Internal Rate of Return of a project, the more desirable the investment to be made. 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 [3].
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 .........
Limitations
Bibliography
- ↑ BERNHARD, Richard H. Discount methods for expenditure evaluation-a clarification of their assumptions. The Journal of Industrial Engineering, 1962, 13.1: 19-27.
- ↑ Haight, Joel M.. (2012). Principles of Industrial Safety - 5.2.5 Net Present Worth. American Society of Safety Professionals. Retrieved from https://app.knovel.com/hotlink/pdf/id:kt012IGYO2/principles-industrial/net-present-worth
- ↑ John R. Graham and Campbell R. Harvey, “The theory and practice of corporate finance: Evidence from the field,” Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.
