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What is Internal Rate of Return (IRR)?

2016-12-08T13:49:43+00:00

The term 'Internal Rate of Return (IRR)' is included in the Accounting edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

The IRR is the acronym for internal rate of return. This IRR proves to be the capital budget rate of return that is utilized in order to determine and compare and contrast various investments’ profitability. It is sometimes known as the discounted cash flow rate of return alternatively, or even the ROR, or rate of return. Where banks are concerned, the IRR is also known as the effective interest rate. The word internal is used to specify that such calculation does not involve facts that are part of the external environment, such as inflation or the interest rate.

More precisely, the internal rate of return for any investment proves to be the interest rate level where the negative cash flow, or net present value of costs, from the investment is equal to the positive cash flow, or net present value of benefits, for the investment. In other words, this IRR will yield a discount rate that causes the net current values of both positive and negative cash flows of a specific investment to cancel out at zero.

These Internal Rates of Return are generally utilized to consider projects and investments and their ultimate desirability. Naturally, a project will be more appealing to engage in or purchase if it comes with a greater internal rate of return. Given a number of projects from which to choose, and assuming that all project benefits prove to be the same generally, the project that contains the greatest Internal Rate of Return will be considered the most attractive. It should be selected with the highest priority of being pursued first.

The assumed theory for companies is that they will be interested in eventually pursuing any investment or project that comes with an IRR that is greater than the expense of the money put into the project as capital. The number of projects or investments that can be run at a time are limited in the real world though. A firm may have a restricted capability of overseeing a large number of projects at once, or they may lack the necessary funds to engage in all of them at a time.

The internal rate of return is actually a number expressed as a percent. It details the yield, efficacy, and efficiency of a given investment or project. This should not be confused with the net present value that instead tells the particular investment’s actual value.

In general, a given investment or project is deemed to be worthwhile assuming that its internal rate of return proves to be higher than either the expense of the capital involved, or alternatively, than a pre set minimally accepted rate of return. For companies that possess share holders, the minimum IRR is always a factor of the investment capital’s cost. This is easily decided by ascertaining the cost of capital, which is risk adjusted, for alternative types of investments. In this way, share holders will approve of a project or investment, so long as its Internal Rate of Return is greater than the cost of the capital to be used and this project or investment creates economic value that is viable for the company in question.

The term 'Internal Rate of Return (IRR)' is included in the Accounting edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.