Internal Rate of Return

A discount rate where the net present value (NPV) of both positive and negative cash flows is equal to zero. This is used to estimate the profit potential for prospective investments. When the IRR is higher than an investor’s required rate of return, that means the project is desirable. Yet if the IRR is below the required rate of return, then the project should be rejected.

What is IRR used for in business? 

Businesses of any size can use the internal rate of return as a way to better evaluate certain projects or investments. Essentially you can look at IRR as the breakeven discount rate which will give a better indication of whether a project or investment will be profitable in the long run. 

Usually, businesses will look to have a larger IRR, that exceeds expectations as this will offer a more lucrative return on their initial investment. The bigger the return, the better. 

A simpler approach

Because the IRR of capital investments and physical goods can become extremely complex over a longer period a simple approach would be the following:

  • An individual receives 15% interest on their $2,000 investment. 
  • Thus, $2,000 at the current period earns $2,000 x 15% = $200 per annum. 
  • $2,000 invested now, will give you $2,300 in one year. 
  • Finally, the IRR here indicates that in one year from now, $2,300 will be worth $2,000.

What we’re seeing here is that the physical value of money or goods decreases over time. Meaning that the same amount of money invested now will deliver better returns in the long run. 

Note: This example is based on an individual investment.

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