Internal Rate of Return (IRR)
The internal rate of return (IRR) is defined as the return rate that makes the present value of cash flows in addition to the final market value of any investment thus bringing it to the level of current market price of the same. Used frequently in determining the worth of an investment, the internal rate of return is an important calculation. An investment is thought to be worthwhile if the internal rate of return is higher than the rate of return provided by an average similar investment. Moreover, a higher internal rate of return of a project indicates the higher desirability of the project.
In addition to indicating the worthwhile of an investment or a project, the internal rate of return also helps in ranking of different projects put on consideration by a firm. Investopedia explains the internal rate of return as the rate of growth that is expected to be generated by a project. Adding more to the point, the internal rate of return can also be weighed against the existing rates of return in the securities market. Provided a collection of pairs implicated in a project, the internal rate of return pursues from the net present value as a function of the return rate.
Being a rate quantity, the internal rate of return of a company is indicates the quality, efficiency, or yield of a project. However, the internal rate of return might, sometimes, overstate the annual equivalent return rate for a project involving interim cash flows being reinvested at a lower rate than what has been estimated. This is because the internal rate of return involves assuming the reinvestment of pro tem cash flows in the projects with equivalent return rates.
Moreover, the internal rate of return is also considered to be a popular and highly suitable choice for evaluating venture capital and similar private equity investments. However, the internal rate of return should not be used to contrast projects featuring different time periods as it does not take the cost of capital into consideration. Therefore, the internal rate of return, as an appraisal of efficiency, can provide better insights in capital constrained issues.
Calculation of internal rate of return can be done using formula of profitability index (PI) when PI = 1.