7.12 : Internal Rate of Return

The Internal Rate of Return (IRR) is a financial tool used to assess the profitability of investments, similar to Net Present Value (NPV). It represents the break-even interest rate where the present value of future cash inflows equals the initial investment, guiding decisions on whether to pursue a project.

IRR is compared to the required rate of return, which is the minimum return expected based on the project's risk and opportunity cost. As the rate where NPV equals zero, IRR is crucial for evaluating more complex investments.

While calculating IRR for a single-period investment is relatively simple, it becomes more challenging for multi-period investments. For instance, take an investment that costs $100 and generates $60 in annual cash flows for two years. Calculating the return on this investment is not immediately straightforward. The IRR identifies the discount rate that equates the present value of these cash flows with the initial investment.

Using the IRR function in Excel or a financial calculator, the IRR can be computed by simply inputting the estimated cash flows. This streamlines the calculation, allowing quick and accurate results without requiring manual trial and error.

By providing a single annual rate of return, IRR simplifies comparing various investment options, regardless of their size or duration, helping decision-makers choose the most profitable projects.