internal rate of return (IRR)
Posted by Ripon Abu Hasnat on Monday, August 25, 2014 | 0 comments
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The
internal rate of return (IRR) or economic rate of return (ERR) is a rate of
return used in capital budgeting to measure and compare the profitability of
investments. It is also called the discounted cash flow rate of return
(DCFROR). In the context of savings and loans the IRR is also called the
effective interest rate. The term internal refers to the fact that its
calculation does not incorporate environmental factors (e.g., the interest rate
or inflation).
The
internal rate of return on an investment or project is the "annualized
effective compounded return rate" or "rate of return" that makes
the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both
positive and negative) from a particular investment equal to zero. It can also
be defined as the discount rate at which the present value of all future cash
flow is equal to the initial investment or in other words the rate at which an
investment breaks even.
In
more specific terms, the IRR of an investment is the discount rate at which the
net present value of costs (negative cash flows) of the investment equals the
net present value of the benefits (positive cash flows) of the investment.
IRR
calculations are commonly used to evaluate the desirability of investments or
projects. The higher a project's IRR, the more desirable it is to undertake the
project. Assuming all projects require the same amount of up-front investment,
the project with the highest IRR would be considered the best and undertaken
first.
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