Internal Rate of Return (IRR) determines the worth of an investment. It measures the expected rate of returns generated by an investment based on internal factors and without considering environmental factors such as interest rates or inflation. Read on to find out the advantage of IRR.
Internal Rate of Return (IRR) or Discounted Cash Flow Rate of Return of an investment is the interest rate at which the net present value of the investment’s income stream becomes zero. It is the interest rate or the discount rate at which the net present value of costs or negative cash flows of the investment equals the net present value of the benefits or positive cash flows of the investment.
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Internal Rate of Return vs Net Present Value
Internal Rate of Return (IRR), like Net Present Value (NPV), is a method of capital budgeting. The NPV method allows measurement of the dollar contributions to the stockholders, but only indicates the value or magnitude of the investment. The IRR method on the other hand reveals the efficiency, quality, or yield of an investment, and reveals to the investors their returns on the amount invested. This upfront revelation of the possible returns of an investment or project makes both the project and the concept intuitively appealing.
Comparing Internal Rate of Return with Net Present Value, IRR incorporates determining the time value of money, which makes the process more valid and reliable. The NPV method on the other hand is complex, and it requires assumptions such as discount rate, likelihood of receiving the cash payment, and the like at each stage.
The biggest advantage of IRR is its simplicity that makes the concept easy to understand. The IRR method allows a simple and direct tool to evaluate an investment and/or communicate the value of a project or investment to people who remain unfamiliar with estimation details.
IRR uses one single discount rate to evaluate every investment, making calculation and comparisons easy. The calculation entails listing out the net cash flows on a periodic (usually monthly or annual) basis, identifying the net present value of the cash flow, and determining the interest rate at which this net present value becomes zero.
The use of cash flows instead of earnings is a major advantage of IRR. This makes the calculation simple, does away with the complexities involved in determining the earnings, ensures that all the transactions remain recorded and no earnings are omitted inadvertently or otherwise, and removes scope for distortions.
Comparisons Among Projects
Among the major uses of IRR is to compare the expected returns generated by different projects. Investors and business owners find out the Internal Rate of Return of investments or new projects and opt for the investments or projects that provide the maximum IRR.
Other things remaining equal, the higher a project's internal rate of return, the more attractive the project becomes for investors.
Investors also use the Internal Rate of Return to benchmark against the established minimum acceptable rate of return or cost of capital to determine whether to make the investment. For instance, comparing the IRR of the investment with the average rates of return in the securities market helps in determining whether to invest in the project or put the money into equity to generate better returns.
- Baker, Samuel, L. “The Internal Rate of Return." University of South Carolina. Retrieved from http://hadm.sph.sc.edu/courses/econ/irr/irr.html on 10 November 2010
- Sigman, Carl. “Internal rate of return, bonds, yields." Retrieved from http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-bonds.pdf on 1o November 2010.
- Siber, W.L. "NPV versus IRR." Retrieved from http://pages.stern.nyu.edu/~wsilber/NPV%20Versus%20IRR.pdf on 10 November 2010.