Internal Rate of Return
buttons.Defining the Internal Rate of Return (IRR)
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 investments. It is also called the "discounted cash flow rate of
return" (DCFROR) or 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).
IRR Showing the position of the IRR on the graph of NPV(r) (r is labeled 'i' in the graph).
The internal rate of return on an investment or project is
the "annualized effective compounded return rate" or "rate of return"
that makes the net present value (NPV as NET*1/(1+IRR)^year) 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
discount 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.
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. 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. Investment may be limited by the availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.
Key Points
- The IRR of an investment is the discount 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.
- The higher a project's IRR, the more desirable it is to undertake the project.
- 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.
Term
- Effective Interest Rate, effective annual interest rate, annual equivalent rate (AER), or simply effective rate – the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears.
Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-budgeting-11/internal-rate-of-return-93/index.html
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