Internal Rate of Return(IRR)

It is rate at which the net present value of cash inflow is balanced to the net present value of cash outflow. Internal rate of return is also called as discounted cash flow rate of return, economic rate of return or simple rate of return.

The internal rate of return is usually determined to find out whether particular investment is feasible or not. It is desirable to have a higher internal return rate. Higher the internal rate of return the better it is for the investment. Internal rate of return is factor that shows the quality, efficiency and yield from a particular investment. Investor usually compares the internal rate of return with cost of capital rate which is also called as hurdle rate, after which they determine whether to proceed further with investment or not.

Two assumption were made while calculating internal rate of return they are

• When there is no interim cash flow.
• When interim investment is made they are made at the calculated internal rate of return.
• It does not consider cost of capital which is a major drawback.

The draw back in internal rate of return is overcome by using modified internal rate of return (MIRR). The basic difference between internal rate of return and modified internal rate of return is that in MIRR the interim positive cash flow is assumed to be made at the cost of capital rate, whereas in IRR it is assumed to be made at the IRR rate itself.

The main advantage with the modified internal rate of return is that it allows the investor to make decision in places where the IRR varies due to variation in positive and negative cash flows.

Internal rate of return calculation

Modified internal rate of return calculation

Where CF denotes the cash flow at the particular period, r denotes the IRR, FV denotes futuristic cash flow and PV denotes the present cash flow. Internal rate of return is one of the widely used capital budgeting method for determining the return on any asset. It uses a discount factor in calculating the return which is not used in NPV method.