## Internal Rate of Return

Read this section about the Internal Rate of Return (IRR). Pay attention to calculating IRR, the advantages and disadvantages of using IRR, calculating multiple Internal Rates of Return, and calculating Modified Internal Rates of Return. Try the problems in this section and check your solutions.

### Defining the IRR

IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments; the higher IRR, the more desirable the project.

#### LEARNING OBJECTIVE

• Explain how Internal Rate of Return is used in capital budgeting

#### 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

The effective interest rate, effective annual interest rate, annual equivalent rate (AER), or simply effective rate is 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.

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 interestrate. " The term "internal" refers to the fact that its calculation does not incorporateenvironmental factors (e.g., the interest rate or inflation).

IRR: Showing the position of the IRR on the graph of NPV(r) (r is labelled '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 the project. 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 availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.

Source: Boundless