Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate at which the net present value of all cash flows from a project equals zero, representing the project's expected annualized rate of return.
Explanation
IRR answers the question: what rate of return does this project earn? It is the discount rate that makes the present value of future cash inflows exactly equal to the initial investment. If the IRR exceeds the organization's required rate of return (hurdle rate), the project is considered financially attractive.
IRR is useful because it expresses a project's return as a percentage, making it easy to compare against the cost of capital or alternative investments. However, IRR has limitations: it assumes cash flows are reinvested at the IRR itself (which may be unrealistic), and it can produce multiple values for projects with alternating positive and negative cash flows.
On the exam, remember that higher IRR is generally better and that a project's IRR should exceed the organization's hurdle rate. You will not need to calculate IRR, but you must understand how to interpret and compare it.
Key Points
- •The discount rate at which NPV equals zero
- •Higher IRR is generally preferred
- •Should exceed the organization's hurdle rate to be viable
- •Expressed as a percentage, making comparisons intuitive
Exam Tip
Select the project with the higher IRR when comparing alternatives. If IRR is below the hurdle rate, the project does not meet the minimum required return.
Frequently Asked Questions
Related Topics
Net Present Value (NPV)
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time, used to assess the profitability of a project or investment.
Return on Investment (ROI)
Return on investment (ROI) is a financial metric that measures the percentage gain or loss generated by an investment relative to its cost, calculated as (Net Profit / Cost of Investment) x 100.
Project Selection Methods
Project selection methods are the techniques organizations use to evaluate and choose which projects to pursue, including mathematical models (NPV, IRR, BCR) and comparative approaches (scoring models, peer review).
Benefit-Cost Ratio (BCR)
The benefit-cost ratio (BCR) is a financial metric that compares the present value of benefits to the present value of costs, expressed as a ratio, to determine whether a project's benefits outweigh its costs.
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Business Environment & Strategy
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