Internal Rate of Return
(IRR)

12manage reaches 100.000 members

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

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 Special Interest Group

Visit the Special Interest Group

Internal Rate of Return Forum

Bernard Lim - Malaysia

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 certificates?"

0

raymond - usa

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"

15

Asad - Pakistan

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?"

1

Cao - China

Weaknesses of IRR

"The primary weaknesses of this method are: - IIR sometimes requires unrealistic assumptions about reinvestment of funds, and - Manual calculation is difficult."

2

Bob - USA

TVM vs 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 get of 0.26%. When I use a TVM calculation and solve for the interest rate/year, I get a return of 3.13%. Why is this and what am I doing right or wrong?"

6

Abbas - Pakistan

IRR vs ROE vs ROA

"How can we explain that IRR is different from Return on Equity and Return on Asset?"

58

m zohar hayat - Pakistan

IRR Formula

"Who can supply the exact mathematical formula of internal rate of return? - thanks.."

16

Muhammad Aamir Azeem - Pakistan

Flat Rate vs. IRR

"In Financial Budgeting & Planning, what is Internal Rate of Return and the difference between Flat Rate and IRR?"

11

Sacky - Namibia

Internal rate of Return

"what will be the internal rate of return at 16% and 20% discount rates.. with a discount factor of 0.947, 0.897, 0.804, 0.761, 0.721, 0.683, 0.647"

5

- Netherlands

IRR

"In a performance management tool I am building for a customer, I want to incorporate a KPI to tell something about the use of capital in the production plant. I intend to incorporate IRR and NPV to give an idea of the rate of return and age of equipment used. Machines are invested in the past; how to ascertain IRR and NPV?"

3

Comment on this Page

Internal Rate of Return Education & Events

Compare with: Net Present Value

Return to Management Hub: Decision-making & Valuation  |   Finance & Investing

More Management Methods, Models and Theory