Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

The Internal rate of return (IRR) is an alternative technique for use in maing capital investment decisions that also takes into account the time value of money. The internal rate of return represents the true interest rate earned on an investment over the course of its entire economic life.

The Internal rate of return (IRR) is “the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the discounted cash outflows.

Sum of discounted cash inflows = sum of the discounted cash outflows.

The Internal rate of return is technique in percentage of judging an investment. IRR is the interest rate that makes the Net Present Value zero.

The IRR can be founded by trial and error by using a number of discount factors until the NPV equal Zero. For example, if we use factor 15% discount factor and get positive NPV. We must therefore try a higher figure. Applying 25% gives a negative NPV. We know then that the NPV will be zero somewhere between 15% and 25%.

Decision Ruling

If IRR is greater than target rate of return / opportunity cost of capital, the investment is profitable and will yield a positive NPV.

  §     If IRR is less than target rate of return / opportunity cost of capital, the investment is unprofitable and will result negative NPV.