Internal Rate of Return (IRR)

Knowledge Center

Summary, forum, best practices, expert tips and information sources.

40 items • 707.722 visits

 Summary

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

 Special Interest Group Join
 Internal Rate of Return Special Interest Group. Special Interest Group (54 members)
 Forum New Topic

Forum about Internal Rate of Return.

 Flat Rate versus IROR (IRR) In Financial Budgeting & Planning, what is IROR and the difference between Flat Rate and IRR? (...) 14
 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 (...) 11   2 comments
 IROR 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 (...) 8   1 comments
 TVM versus IROR (IRR) I seem to get different return or interest rates when using TVM vs and IRR scenario. The scenario is putting \$250 into (...) 8
 IROR (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 tha (...) 5
 IROR (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 chang (...) 5
 🔥 NEW Advantages of IROR (IRR) Method What are the main advantages of using IROR for an investment proposal? (...) 4

The top-rated topics about Internal Rate of Return. Here you will find the most valuable ideas and practical suggestions.

 IROR (IRR) versus ROE versus ROA How can we explain that IRR is different from Return on Equity and Return on Asset? (...) 77   1 comments
 IROR (IRR) Formula Who can supply the exact mathematical formula of IROR? - thanks.. (...) 28   2 comments
 Calculating IROR 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 inte (...) 21   2 comments
 Weaknesses of IROR (IRR) The primary weaknesses of this method are: - IIR sometimes requires unrealistic assumptions about reinvestment of f (...) 5   3 comments

 Sensitivity AnalysisDefine Minimum or Maximum Margins of the IRRA sensitivity analysis is very helpful to define minimum or maximum margins of the IRR. A series of sensitivity analys (...)

Various sources of information regarding Internal Rate of Return. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops.

 Why Managers prefer IRRCapital BudgetingFinance textbooks recommend the use of Net Present Value (NPV) as the evaluation tool for Capital Budgeting. Yet surveys (...) Analyzing Financial FeasibilityFinancial Feasibility Analysis, Project Selection, ROI, NPV, IRRPresentation about Feasibility Studies in the Financial Area. The presentation includes the following sections: 1. Fina (...) Capital BudgetingCalculate NPV, IRR, ROCBasic capital budgeting analysis for a project. Compute NPV, IRR and ROI. Spreadsheet by Aswath Damodaran. (...) IRR or NPV?Investment AppraisalTwo of the most important criteria for choosing between capital investment projects are net present value (NPV) and inte (...)

 News Videos Presentations Books More

Compare with: Net Present Value