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Internal Rate of Return

Internal Rate of Return

It is used to calculate the rate of return or profits from an investment. It is used in capital budgeting. Its also called as discounted cash flow rate of return. It is defined as the annualized effective compounded rate of return that can be earned on the capital invested.

In general terms the higher a project’s IRR the more desirable it is to undertake the project. It is used to rank the projects which a firm’s considering.

The formula for IRR is
IRR = CF0 + CF1 /(1+r)1 + CF2/(1+r)^2 + CF3/(1+r)^3 +. . . . + CFn/(1+r)^n = 0.

Here CF is the Cash Flow generated in the specific period. IRR is denoted by r is to be calculated using trail and error method.

Because 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.

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. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company.

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