Internal Rate of Return
(IRR)

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Calculation of the true interest yield expected from an investment. Explanation of Internal Rate of Return.

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What is Internal Rate of Return? Definition

The Internal Rate of Return (IRR) is the discount rate that delivers a net present value of zero for a series of future cash flows. It is an Discounted Cash Flow (DCF) approach to valuation and investing. As is Net Present Value (NPV). IRR and NPV are widely used to decide which investments should be undertaken, and which investments not to make.
 

Difference of IRR and NPV

The major difference is that while Net Present Value is expressed in monetary units (Euro's or Dollars for example), the IRR is the true interest yield expected from an investment expressed as a percentage. 


Internal Rate of Return is the flip side of Net Present Value and is based on the same principles and the same calculations. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment causes a positive NPV (and should be made). And above which an investment causes a negative NPV (and should be avoided). It's the break-even discount rate, the rate at which the value of cash outflows equals the value of cash inflows.
 

Many people find the percentages of IRR easier to understand than Net Present Value. Another benefit from IRR is that it can be calculated without having to estimate the (absolute) cost of capital.


The IRR approach

When IRR is used, the usual approach is to select the projects whose IRR exceeds the cost of capital (often called hurdle rate when used in the IRR context). This may seem simple and straightforward at first sight. However a major disadvantage of using the Internal Rate of Return instead of Net Present Value is that if managers focus on maximizing IRR and not NPV, there is a significant risk in companies where the return on investment is greater than the Weighted Average Cost of Capital (WACC): that managers will not invest in projects that are expected to earn more than the WACC, but less than the return on existing assets. IRR is a true indication of a project's annual return of investment only when the project generates no interim cash flows - or when those interim investments can be invested at the actual IRR.


The aim of the value-oriented manager should be to invest in any project that has a positive NPV! If IRR usage is unavoidable, then managers are advised to use so called Modified IRR (which, while not perfect, at least allows to set more realistic interim reinvestment rates) and additionally to keep a close look on interim cash-flows, especially if they are biased to the beginning of the project period (the distortion is bigger then).


In other words: the aim should not be to maximize the Internal Rate of Return, but to maximize Net Present Value.


Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining the Value.. -

Book: James R. Hitchner - Financial Valuation: Applications and Models -

Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive Guide -


Internal Rate of Return Forum
  Advantages of Internal Rate of Return (IRR) Method
What are the main advantages of using Internal Rate of Return for an investment proposal?...
     
 
  Internal Rate of Return and Real Estate
As an example if an owner puts up $7,500,000 equity to buy an office building. After 10 years it threw of $7,000,000 of cash flow. The owner wants to turn the project over to a management company to manage. If IRR is used to see how well the manager ...
     
 
  Internal Rate of Return (IRR) Based KPIs
Given that IRR and NPV methods are about making decisions about the future based on expected cash flows I'm not sure that a KPI based on these will give any useful information. Surely the sensible KPI is a measure of the deviation of actual result fr...
     
 
  Calculating the Rate of Return
A leading broker has advertised money multiplier certificates that will triple your money in 9 years. If you buy one for $333.33 today, it will pay you $1000 at the end of nine years. What rate of return will you earn on these money multiplier certif...
     
 
  Calculating Internal Rate of Return
A project has an initial outlay of $4000. It has a single payoff at the end of year 4 of $6996.46.
What is the internal rate of return for the project?...
     
 
  Internal Rate of Return (IRR) in Real Value?
How to calculate IRR when cash flows are in real value?? Can IRR be calculated in real value?? How can the rate be changed to nominal value?...
     
 
  Weaknesses of Internal Rate of Return (IRR)
The primary weaknesses of this method are:
- IIR sometimes requires unrealistic assumptions about reinvestment of funds, and
- Manual calculation is difficult....
     
 
  TVM versus Internal Rate of Return (IRR)
I seem to get different return or interest rates when using TVM vs and IRR scenario. The scenario is putting $250 into a fund for 36 months for a total investment of $9,000. The final return is $9,423. When I use the IRR to calculate the return I ...
     
 
  Internal Rate of Return (IRR) Formula
Who can supply the exact mathematical formula of internal rate of return? - thanks.....
     
 
  Flat Rate versus Internal Rate of Return (IRR)
In Financial Budgeting & Planning, what is Internal Rate of Return and the difference between Flat Rate and IRR?...
     
 
  Internal Rate of Return (IRR) versus ROE versus ROA
How can we explain that IRR is different from Return on Equity and Return on Asset?...
     
 

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Best Practices - Internal Rate of Return Premium

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Sensitivity Analysis

A sensitivity analysis is very helpful to define minimum or maximum margins of the IRR.
A series of sensitivity analyses shall be conducted to i...
Usage (application): Define Minimum or Maximum Margins of the IRR
 
 

Resources - Internal Rate of Return Premium

Why Managers prefer IRR

Finance textbooks recommend the use of Net Present Value (NPV) as the evaluation tool for Capital Budgeting. Yet surveys of managers have consistently...
Usage (application): Capital Budgeting
 

Analyzing Financial Feasibility

Presentation about Feasibility Studies in the Financial Area. The presentation includes the following sections:
1. Financial Feasibility Analysis...
Usage (application): Financial Feasibility Analysis, Project Selection, ROI, NPV, IRR
 

Capital Budgeting

Basic capital budgeting analysis for a project. Compute NPV, IRR and ROI. Spreadsheet by Aswath Damodaran....
Usage (application): Calculate NPV, IRR, ROC
 

IRR or NPV?

Two of the most important criteria for choosing between capital investment projects are net present value (NPV) and internal rate of return (IRR). Alt...
Usage (application): Investment Appraisal
 
 

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