Internal Rate of Return

Advantages of the IRR Method

The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investment. IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake it.

Internal rate of return Internal rate of return is the rate at which the NPV of an investment equals 0.

One advantage of the IRR method is that it is very clear and easy to understand. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would 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.

In other words, an investment is considered acceptable if its internal rate of return exceeds an established minimum acceptable rate of return or cost of capital. Most analysts and financial managers can understand a company's opportunity costs.

If the IRR exceeds this rate, then the project provides financial accretion. However, if the rate of an investment is projected to be below the IRR, then the investment would destroy company value. IRR is used in many company financial profiles due to its clarity for all parties.

The IRR method also uses cash flows and recognizes the time value of money. Compared to the payback period method, IRR takes into account the time value of money because it expects a high interest rate from investments.

In addition, the internal rate of return is a rate quantity, an indicator of an investment's efficiency, quality, or yield. This contrasts with the net present value, which is an indicator of an investment's value or magnitude.