What is the Internal Rate of Return (IRR)?
The internal rate of return (IRR), also know as the economic rate of return (ERR), is a rate of return used in capital budgeting to determine the rate of growth that an investment is expected to generate.
People work out the internal rate of return to decide whether a project is worth doing, i.e. is it worth spending money on.
Just simple ‘rate of return’ is the ratio of the profit one makes on an investment over its initial cost.
The internal rate of return on an investment is the “annualized effective compounded return rate” or discount rate that makes the net present value of all cash flows from an investment equal to zero.
Essentially this means that the IRR of an investment is the interest rate at which the current value of costs of the investment is the same as the current value of the investment’s benefits.
An IRR view of the cash flow stream is an investment view: paid out funds are compared to returns.
When the internal rate of return is used in the context of savings and loans it is also referred to the effective interest rate.
The reason why it is internal is because it does not account for environmental factors (such as inflation or interest rate). The internal rate of return is an indicator of an investment’s quality and yield. This is different to net present value – which provides information on the value or magnitude of an investment.
According to ft.com/lexicon, the Internal Rate of Return is:
“A measure of the value of an investment, expressed as a percentage and calculated by comparing the profit in a year with the amount that was originally invested.”