The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero. The higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR probably would be considered the best. The internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate.
The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.
IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of annual return over time. In addition to being used by companies to determine which capital projects to use, IRR can help investors determine the investment return of various assets.
IRR Formula:
0=NPV=t=1∑T(1+IRR)tCt−C0
where:
Ct=Net cash inflow during the period t
C0=Total initial investment costs
IRR=The internal rate of return
t=The number of time periods
