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.

Advantages of the IRR Method

The IRR method is easily understood, it recognizes the time value of money, and compared to the NPV method is an indicator of efficiency.


LEARNING OBJECTIVE

  • Describe the advantages of using the internal rate of return over other types of capital budgeting methods

KEY POINTS

    • The IRR method is very clear and easy to understand. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital.
    • The IRR method also uses cash flows and recognizes the time value of money.
    • The internal rate of return is a rate quantity, an indicator of the efficiency, quality, or yield of an investment.

TERMS

  • cost of capital

    the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

  • capital budgeting

    The budgeting process in which a company plans its capital expenditure (the spending on assets of long-term value).


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 the project.


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 is greater than an established minimum acceptable rate of return or cost of capital. Most analysts and financial managers can understand the opportunity costs of a company. 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 its clarity for all parties.

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

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