IRR Definition
The Internal Rate of Return is the discount rate which makes the Net Present Value(NPV) of all cash flows from a project equal to ‘zero’. Internal Rate of Return can also be defined as the return on investment.
Explanation
Internal Rate of Return indicates the feasibility of a project. Which means higher the Internal Rate of Return of the project, the more feasible is the project to undertake.
Decision Making
Internal Rate of Return helps a firm to decide which project to consider amongst several other projects. The project with the highest Internal Rate of Return would be considered the best to undertake. Internal Rate of Return also helps the firm in forecasting the expected profitability and growth of that particular chosen project.[sky]
In other words, you can also think of Internal Rate of Return as an expected growth rate of a chosen project. Though the actual rate of a project may differ from the estimated Internal Rate of Return, but a project with highest Internal Rate of Return will have the strongest chances of providing high growth as compared to the other available projects.
Internal Rate of Return in Securities
Internal Rate of Return can also be used for securities. In security market, Internal Rate of Return can also be compared with several other rate of return of different securities. In this case. Internal Rate of Return helps in forecasting the profit from a particular security.
CALCULATIONS:
Internal Rate of Return calculation is similar to the calculation of Net Present Value (NPV). Net Present Value determines present value using a predefined discount rate. Whereas. Internal Rate of Return calculates the discount rate that makes Net Present Value equal to zero.
Discount Rate:
Discount Rate can be defined as a cost of borrowing. The decision is based on the comparison of discount rate and Internal Rate of Return. The project will be accepted if the Internal Rate of Return is greater than the discount rate or cost of borrowing.
Example of Internal Rate of Return
ABC company needs to purchase a new machine as a replacement of their old machine. ABC company has available options of 2 machines which serves the same function. The data is as follows:
Machine A costs $ 100,000 and will provide savings of $ 25,000 for next 5 years.
Machine B costs $ 75,000 and will provide savings of $ 20,000 for next 5 years.
ABC company has a discount rate of 10%.
SOLUTION:
The IRR for machine A is less than the discount rate of 10%, in other words it cost more to borrow the money than the machine will return. In contrast machine B has an IRR of 10.42%, this means that the machine will return more than the cost of borrowing the money and is therefore a good investment.