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Concept
Internal rate of return
Summary
Internal rate of return (IRR) is a method of quantifying the merits of a project or investment opportunity. The calculation is termed internal because it depends only on the cash flows of the investment being analyzed and excludes external factors, such as returns available elsewhere, the risk-free rate, inflation, the cost of capital, or financial risk.
The method may be applied either ex-post or ex-ante. Applied ex-ante, the IRR is an estimate of a future annual rate of return. Applied ex-post, it measures the actual achieved investment return of a historical investment.
It is also called the discounted cash flow rate of return (DCFROR) or yield rate.
The IRR of an investment or project is the "annualized effective compounded return rate" or rate of return when the net present value (NPV) of all cash flows (both positive and negative) from the investment is assumed to be equal to zero. Equivalently, it is the interest rate at which the net present value of the future cash flows is equal to the initial investment, and it is also the interest rate at which the total present value of costs (negative cash flows) equals the total present value of the benefits (positive cash flows).
IRR, an acronym for Internal Rate of Return, is a crucial concept in the realm of finance. It represents the return on investment achieved when a project reaches its breakeven point, meaning that the project is only marginally justified as valuable. To gain a comprehensive understanding of IRR, it is essential to grasp another fundamental concept known as NPV, or Net Present Value. When NPV demonstrates a positive value, it indicates that the project is expected to generate value, thereby receiving approval from management to proceed. Conversely, if NPV shows a negative value, management will likely decide against moving forward with the project.
In essence, IRR signifies the rate of return attained when the NPV of the project reaches a neutral state, precisely at the point where NPV breaks even.
Official source
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