Internal Rate of Return

Internal Rate of Return of IRR is a capital budgeting tool that is used to assess the viability of an investment opportunity. IRR is the true rate of return that a project is capable of generating. It is a metric that tells you about the investment is going to be in net benefit situation or not. For example, you take an investment of one million that promises the cash flows for next five years. If the IRR is higher than the cost of capital of the project, then the project is worthwhile. IRR is the rate of return at which the NPV of any project is equal to zero, that means if cash flows of a project are discounted at the rate of IRR, the present value of the cash inflows will be exactly equal to the initial investment of that project. Because of this logic the following formula is depicted that uses hit and trial approach until we find a close estimation of IRR of a project.


Formula

IRR can be calculated using the excel, a financial calculator and by this formula.

Criticism on IRR

The IRR and NPV are used side by side in capital budgeting and the it is adviseable that the IRR should be used as a supporting measure with NPV. This is because the IRR sometimes mislead managers about taking wrong investment decisions. IRR is a relative measure rather than an absolute measure. This means that IRR will ignore the size and length of the projects. Also often IRR calculations show more than one IRR for a project that has non conventional cash flows stream. In which case only NPV should be used or MIRR should be used.

Learn more about IRR in the following video.


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