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Internal Rate of Return

Internal rate of return (IRR) is a capital budgeting technique used to estimate the profitability of potential investments. IRR is defined as the discount rate that makes the net present value of all cash flows from a project equal to zero. It incorporates the time value of money by requiring the initial investment to be compensated by future net cash flows. While IRR provides a simple percentage return, it has disadvantages such as providing multiple rates of return for projects with varying cash flows over time and not considering the actual dollar value of cash flows.

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58 views1 page

Internal Rate of Return

Internal rate of return (IRR) is a capital budgeting technique used to estimate the profitability of potential investments. IRR is defined as the discount rate that makes the net present value of all cash flows from a project equal to zero. It incorporates the time value of money by requiring the initial investment to be compensated by future net cash flows. While IRR provides a simple percentage return, it has disadvantages such as providing multiple rates of return for projects with varying cash flows over time and not considering the actual dollar value of cash flows.

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INTERNAL RATE OF RETURN

Internal rate of return (IRR) is the discount rate at which the net present value of an investment is
zero. IRR is one of the most popular capital budgeting technique.

Companies invest in different projects to generate value and increase their shareholders wealth,
which is possible only if the projects they invest in generate a return higher than the minimum rate
of return required by the providers of capital (i.e. shareholders and debt-holders). The minimum
required rate of return is called the hurdle rate.

IRR is a discounted cash flow (DCF) technique which means that it incorporate the time value of
money. The initial outlay/investment in any project must be compensated by net cash flows which
far exceed the initial investment. The higher those cash flows when compared to the initial outlay,
the higher will be the IRR and the project is a promising investment.
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of
potential investments. The internal rate of return is a discount rate that makes the net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same
formula as NPV does.

The major advantage of IRR method of evaluating the project is that it simply tells what the project
under concern will return in terms of percentage. Now the evaluator only needs to decide with
which rate to compare it with. We do not need to decide a hurdle rate in advance. A mistake in
deciding hurdle rate will not affect the result of this method.

The major disadvantage of internal rate of return are its problem in analyzing a non-conventional
project where cash flow stream has various positive and negative cash flows in various years. In this
situation, it will give Multiple Internal Rate of Return (IRR). Another problem is that it does not
consider the dollar value. The business of a roadside vendor who hardly earns his leaving will have
higher IRR than a very big and stable business. The vendor must be earning say 1000 dollar a year
whereas the profit of that big business may be in millions.

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