Internal Rate of Return

What Is Internal Rate of Return?

The internal rate of return (IRR) is used to determine the likely profit of an investment or project. It displays the annualized return percentage that an investor would obtain, assuming the anticipated cash inflows and outflows occur, and it is also the rate where the NPV of those anticipated cash flows equals zero.

Key Features of IRR

Discount Rate: The IRR is the average of the two internal rates which satisfy the fund requirement and this makes the NPV equal zero.

Time Value of Money: IRR depicts that the future cashflows will always be lesser than the today’s inflow because of the potential investment.

Comparison Tool: Investors use it to measure various opportunities in investment IRR because higher means that it’s a more “attractive” opportunity due to better returns.

Limitations of IRR

Reinvestment Assumption: IRR expects that further inflows will be reinvested at IRR rate to generate sufficient returns which isn’t always true.

Multiple IRRs: Some projects having distributed cash flows are likely to lead to several internal rates of returns or IRRS which make decision making challenging.

Sensitivity to Cash Flow Estimates: The estimation of future cash flows tends to be unpredictable, and the IRR relies on these cash flows to make predictions.