Internal Rate of Return, often simply referred to as the IRR, is the discount rate at which the net present value of future cash flows from an investment are equal to zero. It is a metric which is used for estimating the profitability of potential investments . Management can use this return rate to compare other investments and decide what capital projects should be funded and what ones should be scrapped.
INVESTING BASED ON IRR :-
According to the IRR rule, a project or investment must be selected only if the internal rate of return of the project is greater than the minimum required rate of return or the cost of capital .
On the other hand, if the IRR of a project is lower than the cost of capital then that project must be rejected .
FORMULA FOR CALCULATING IRR
The IRR formula is calculated by equating the sum of the present value of future cash flow less the initial investment to zero. The IRR can only be derived by using trial and error methods .
IRR = (( Cash flows ))/( 1+r ) ^ i – Initial investment
Cash flows = Cash flows in the time period
r = discount rate
I = time period
The rate at which the cost of investment and the present value of future cash flows match will be considered as the ideal rate of return. A project that can achieve this is a profitable project.
ADVANTAGES OF IRR :-
- It is very easy to understand IRR since it is expressed in percentage terms .
- It is most ideal for analyzing capital budgeting projects .
DISADVANTAGES OF IRR :-
- Sometimes IRR may have multiple values so it may lead to differing results .
- IRR heavily relies on projection of future cash flows which is very difficult to predict .
In simple words , Internal rate of return (IRR) is the minimum discount rate that management uses to identify what capital investments or future projects will yield profitable returns and be worth pursuing and what projects need to be rejected .