Internal Rate of Return, Discount Rate, IRR

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Internal rate of return (IRR) is a measure of the yield or efficiency of an investment. It is also known as the discounted cash flow rate of return (DCFROR) and is the yearly compounded return rate at which an investment delivers results. In other words, the IRR is the discount rate (DR), which makes the net present value (NPV) of the income stream from an investment equal to zero.

Internal Rate of Return: Calculation

The internal rate of return (IRR) can be calculated using the following formula:

formula

where,

t = time,

C = cash flow,

r = internal rate of return, and

NPV = net present value.

For instance,

If the cash flow or income stream from an investment is as follows:

Period 0 = -100

Year 1 = 40

Year 2 = 59

Year 3 = 55

Year 4 = 20,

then

formula2

This translates to an IRR of about 28.6%. This means that $28.6 is produced for each $100 that is invested for four years.

Internal Rate of Return: Importance

The internal rate of return is basically a capital budgeting metric. This is used extensively by companies to determine whether or not they should make a particular investment. It reflects the quality of an investment. It is also used to makecomparisons among different investment options. An investment is a good option if its IRR is higher than the rate of return that can be earned by investing the money elsewhere at equal risk.

The IRR can be used to calculate the time by which your money will devalue completely. So, if the IRR is say 9%, you would want to put your money into an investment that offers a rate of return that is more than 9%. If this is not the case, then your money will devalue.

While the internal rate of return is an important indicator of the quality of an investment, it is not a good measure in case a project is likely to have cash outflows after generating cash inflows for a while. The main pitfall of the internal rate of return is that it does not take into consideration the cost of the investment.

 

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