INTERNAL RATE OF RETURN - IRR
The discount rate often used in
capital budgeting that makes the net present value of all cash flows from a
particular project equal to zero. Generally speaking, the higher a project's
internal rate of return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a firm is
considering. Assuming all other factors are equal among the various projects,
the project with the highest IRR would probably be considered the best and undertaken
The internal rate of return (IRR)
is a rate of return used in capital budgeting to measure and compare the
profitability of investments. It is also called the discounted cash flow rate
of return (DCFROR) or simply the rate of return (ROR). In the context of
savings and loans the IRR is also called the effective interest rate. The term
internal refers to the fact that its calculation does not incorporate
environmental factors (e.g., the interest rate or inflation).
Internal Rate of Return
This method equates the net
present value of the project to zero. The project is evaluated by comparing the
calculated Internal rate of return to the predetermined required rate of
return. Projects with Internal rate of return that exceed the predetermined
rate are accepted. The major weakness is that when evaluating mutually
exclusive projects, use of Internal rate of return may lead to selecting a
project that does not maximize the shareholders' wealth.
The internal rate of return on an
investment or project is the "annualized effective compounded return
rate" or discount rate that makes the net present value of all cash flows
(both positive and negative) from a particular investment equal to zero.
In more specific terms, the IRR
of an investment is the interest rate at which the net present value of costs
(negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment.
Internal rates of return are
commonly used to evaluate the desirability of investments or projects. The
higher a project's internal rate of return, the more desirable it is to
undertake the project. Assuming all other factors are equal among the various
projects, the project with the highest IRR would probably be considered the
best and undertaken first.
A firm (or individual) should, in
theory, undertake all projects or investments available with IRRs that exceed
the cost of capital. Investment may be limited by availability of funds to the
firm and/or by the firm's capacity or ability to manage numerous projects.
Important: Because the internal
rate of return is a rate quantity, it is an indicator of the efficiency,
quality, or yield of an investment. This is in contrast with the net present
value, which is an indicator of the value or magnitude of an investment.
An investment is considered
acceptable if its internal rate of return is greater than an established
minimum acceptable rate of return or cost of capital. In a scenario where an
investment is considered by a firm that has equity holders, this minimum rate
is the cost of capital of the investment (which may be determined by the
risk-adjusted cost of capital of alternative investments). This ensures that
the investment is supported by equity holders since, in general, an investment
whose IRR exceeds its cost of capital adds value for the company (i.e., it is