The
internal rate of return (IRR) or economic rate of return (ERR) is a
rate of return used in capital budgeting to measure and compare the
profitability of investments. It is also called the discounted cash flow
rate of return (DCFROR). In the context of savings and loans the IRR is
also called the effective interest rate. The term internal refers to
the fact that its calculation does not incorporate environmental factors
(e.g., the interest rate or inflation).
The
internal rate of return on an investment or project is the "annualized
effective compounded return rate" or "rate of return" that makes the net
present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both
positive and negative) from a particular investment equal to zero. It
can also be defined as the discount rate at which the present value of
all future cash flow is equal to the initial investment or in other
words the rate at which an investment breaks even.
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In
more specific terms, the IRR of an investment is the discount rate at
which the net present value of costs (negative cash flows) of the
investment equals the net present value of the benefits (positive cash
flows) of the investment.
IRR
calculations are commonly used to evaluate the desirability of
investments or projects. The higher a project's IRR, the more desirable
it is to undertake the project. Assuming all projects require the same
amount of up-front investment, the project with the highest IRR would be
considered the best and undertaken first.
