A major application of IRR is to determine the attractiveness or viability of projects or investments, and to choose the best project or investment among different alternatives.
An investment becomes attractive for investors, or a project becomes viable for a business if the internal rate of return of the investment or project is greater than the cost of capital, which is the established minimum acceptable rate of return by deploying that capital elsewhere. For instance, an investment of $10,000 to start a retail store might have an IRR of 10 percent. The same amount of $10,000 invested in fixed deposit may yield 6 percent, making investment in the retail business a more attractive preposition. The same amount, if invested in the stock market might however provide returns of 12 percent, making the alternative of investing in the stock market more attractive than starting the retail business.
The uses of IRR extend to ranking projects or various alternatives in terms of their attractiveness. The higher a project's internal rate of return, the more attractive such investment become for investors, or the more desirable it becomes to undertake a project. For instance, the IRR of the proposed retail store being 10 percent and the IRR of a proposed daycare center being 15 percent, starting a day care center makes better sense than starting a retail outlet, other things such as risks and external environment factors remaining equal.
IRR is a primary factor that companies consider when starting a business. For instance, if the IRR of construction projects remains high, more and more entrepreneurs take up this attractive business preposition and the economy may witness a construction boom. On the other hand, if input costs increase and the IRR for construction business become low, denoting reduced profits, the construction industry may stagnate even if external environment conditions such as the state of the economy remains favorable.