Internal rate of return

Internal rate of return (IRR) is defined and refers to the discount rates that are utilized in the process of capital budgeting. Under IRR the net present value of all cash flows of a particular project is equal to zero. IRR is the rate of return in accounting that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity.

IRR helps in determining if the given investment is worthwhile. An investment would be worthwhile if the internal rate of return is greater than the return of an average similar investment opportunity, or if it is greater than the cost of capital of the opportunity. Internal rate of return is also known as economic rate of return (ERR) or dollar-weighted rate of return. IRR is also used to compare against prevailing rates of return in the securities market. When a firm does not find any projects with the IRR which is greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

While calculating the internal rate of return it is important to note that the competing projects are an important aspect to decide whether the projects are viable and which ones are not, the IRR is not the only deciding factor. The business owners may consider benefits other than profit that may be achieved by pursuing a given project, and find them to be sufficient reason to go with a project that provides a lower return in profits, but creates other benefits that have a long term positive effect on the company. Hence the internal rate of return is only one tool that is used to decide if a given project is in the best interests of a business, rather than just assessing the outcome of implementing the project.

Questions

•  What is internal rate of return?
• Why is internal rate of return not the only deciding factor for projects?