What is IRR (Internal Rate of Return)?
<iframe width=”560″ height=”315″ src=”https://www.youtube.com/embed/kZpdrbgz4DE” frameborder=”0″ allow=”accelerometer; autoplay; encrypted-media; gyroscope; picture-in-picture” allowfullscreen></iframe><p><i> Video created by <a href=”https://www.financestrategists.com/terms/irr/”>Finance Strategists</a>.</i></p>
Internal Rate of Return (IRR) Definition
The Internal Rate of Return is also often used to mean the rate at which the net present values of all cash inflows and cash outflows of an investment decision net to zero.
If the calculated IRR is greater than or equal to the company’s known discount rate, the investment decision is profitable.
Example of IRR
For example, if investing in a piece of machinery costs $10,000 today and we estimate that the machine will make $4,000 per year for the next three years, then the lowest acceptable IRR for the project would be the rate necessary to make the $12,000 earned over three years to equal $10,000 of money today.
In this case, the minimum IRR is 9.70%.
If we also know that the return made from keeping that money in our savings account is 2% then we consider that 9.7% is greater than 2% and make the investment decision.
NPV vs IRR
Both Net Present Value and Internal Rate of Return can be used to evaluate an investment decision.
However, Net Present Value focuses on the magnitude of value generated by an investment whereas Internal Rate of Return focuses on the efficiency or degree of an investment.
For this reason, IRR is a useful model for judging initial investments that are removed by degrees of magnitude such as investing $1,000 versus $100,000.
It is important to remember that IRR is a starting point in evaluating investments.
An initially profitable IRR could become unprofitable when also considering external market factors and opportunity costs.