The internal rate of return, or IRR, is the average annual return generated by an investment over a specific number of years from the time the investment is made. The IRR is a component of an investment's net present value and accounts for an investment's net cash flow, which is the difference between its projected revenues less its projected costs, or expenses. The IRR is effective when used as a comparative gauge for analyzing several investment options. Investments having higher IRRs are preferable to those having lower IRRs, and may apply to financial assets, such as stocks and bonds, as well as business projects and capital investments, like manufacturing equipment and factories.
How Does it Work?
When an investor, which might be an individual or a company, analyzes the viability of a prospective investment, such as a stock or a client project, the investor is interested in that investment's net present value (NPV). The NPV is an arithmetic function that expresses something's estimated future value at the present time. The internal rate of return is the rate that would, in theory, make an investment's NPV equal to zero. This means that the IRR might be positive or negative. A negative IRR value indicates that an investment is likely to lose money and should be ruled out. A positive IRR value indicates viable future returns and should be maximized.
Net Present Value
Net present value, as part of which internal rate of return is expressed, is the value today of an investment's possible future returns in terms of its net inflow of cash when subtracted from the cost of the investment. The figure derived from this calculation may be positive or negative and indicates, respectively, whether an investment should or should not be taken on.
An investment's internal rate of return is derived by solving the net present value equation for the rate of return, substituting zero for the NPV value itself. Similar to solving the NPV, solving for the rate of return may yield either a positive or negative IRR value. Calculated in conjunction with an investment's specific NPV, this IRR calculation provides an estimate of the annual cash returns accounting for revenues and expenses for a specific number of years into the future.
Implications for Companies
Companies use the internal rate of return as part of the decision-making and pricing process on capital investments, such as production premises and machinery, and on project opportunities from clients. Though a company is best served to use the IRR as a comparative measure to choose from among possible projects and investments, the IRR may be gauged against its own fiscal goals. In other words, if a company's goal for an investment is a return of 9 percent annually, it should take on that investment provided that the associated IRR is calculated at 9 percent or higher.
When calculating the internal rate of return on an investment, companies and individual investors need to be aware that an IRR value is only an estimate of the average annual net return over some given number of years. An investment's actual net returns in any given year may differ because of such variables as unforeseen expense increases and an uncertain economic atmosphere.