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Internal Rate of Return

from QFinance: The Ultimate Resource

Internal rate of return (IRR) is another analytical tool based on the time value of

money principle. Some regard it as the companion to net present value.

WHAT IT MEASURES

Technically, the interest rate that makes the present value of an investment’s

projected cash flows equal to the cost of the project; practically speaking, the rate

that indicates whether or not an investment is worth pursuing.

WHY IT IS IMPORTANT

The calculation of internal rate of return (IRR) is used to appraise the prospective

viability of investments and capital projects. It is also called dollar-weighted rate of

return.

Essentially, IRR allows an investor to find the interest rate that is equivalent to the

monetary returns expected from the project. Once that rate is determined, it can be

compared to the rates that could be earned by investing the money elsewhere, or

to the weighted cost of capital. IRR also accounts for the time value of money.

HOW IT WORKS IN PRACTICE

How is IRR applied? Assume, for example, that a project under consideration costs

$7,500 and is expected to return $2,000 per year for five years, or $10,000. The

IRR calculated for the project would be about 10%. If the cost of borrowing money

for the project, or the return on investing the funds elsewhere, is less than 10%, the

project is probably worthwhile. If the alternate use of the money will return 10% or

more, the project should be rejected, since from a financial perspective it will break

even at best.

Typically, management requires an IRR equal to or higher than the cost of capital,

depending on relative risk and other factors.

The best way to compute an IRR is by using a spreadsheet (such as Excel) or a

financial calculator, which do it automatically, although it is crucial to understand

how the calculation should be structured. Calculating IRR by hand is tedious and

time-consuming, and requires the process to be repeated to run sensitivities.

RELATED ARTICLES

Calculating Internal Rate of Return in BUSINESS: The

Ultimate Resource

WHAT IT MEASURES

Technically, the interest

rate that makes the

present value of an

investment's projected

cash flows equal to the

cost of the pro

556 words from A&C

Black

FEASIBILITY STUDY in Barron's Business

Dictionaries: Dictionary

of Accounting Terms

evaluation of a

contemplated project or

course of action,

according to

preestablished criteria

(such as NET PRESENT

VALUE, INTERNAL

RATE OF RETURN,

50 words from Barron's

Educational Series

MUTUALLY

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If using Excel, for example, select the IRR function. This requires the annual cash

flows to be set out in columns, and the first part of the IRR formula requires the cell

reference range of these cash flows to be entered. Then a guess of the IRR is

required. The default is 10%, written 0.1.

If a project has the following expected cash flows, then guessing IRR at 30% returns

an accurate IRR of 27%, indicating that if the next best way of investing the money

gives a return of -20%, the project should go ahead.

Now –2,500

Year 1 1,200

Year 2 1,300

Year 3 1,500

TRICKS OF THE TRADE

IRR analysis is generally used to evaluate a project’s cash flows rather than

income because, unlike income, cash flows do not reflect depreciation and

therefore are usually more instructive to appraise.

Most basic spreadsheet functions apply to cash flows only.

As well as advocates, IRR has critics who dismiss it as misleading, especially

as significant costs will occur late in the project. The rule of thumb that “the

higher the IRR the better” does not always apply.

For the most thorough analysis of a project’s investment potential, some

experts urge using both IRR and net present value calculations, and

comparing their results.

MORE INFO

Book:

Walsh, Ciaran. Key Management Ratios. 4th ed. London: FT Prentice

Hall, 2008.

Article:

EXCLUSIVE INVESTMENTS in Barron's Business

Dictionaries: Dictionary

of Accounting Terms

group of CAPITAL

BUDGET projects that

compete with one

another in such a way

that the acceptance of

one automatically

excludes all others from

furth

69 words from Barron's

Educational Series

internal rate of return in The Penguin

Dictionary of Economics

That rate of interest

necessary in

discounting the flow

over time of net

revenue generated by

an investment such that

the present value of...

302 words from

Penguin

internal rate of return (IRR) in Dictionary of

Economics, Wiley

Also called time

adjusted rate of return ;

the rate of interest that

equates the initial

11/3/18, 4(59 AMInternal Rate of Return | QFinance: The Ultimate Resource - Credo Reference

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Baker, Samuel L. “The internal rate of return.” March 28, 2006. Online

at: sambaker.com/econ/irr/irr.html.

See Also:

Comparing Net Present Value and Internal Rate of Return

Using IRR for M&A Financing

Copyright © Bloomsbury Information Ltd, 2009, 2011, 2012, 2013, 2014

Chicago Harvard MLA

Internal rate of return. (2014). In Qatar Financial Center, & Qatar Financial Center

(Eds.), QFinance: the ultimate resource (5th ed.). London, UK: A&C Black.

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