The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)".

Investopedia Says:
You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

Method used to determine the Policyholder's return on premiums paid into a life insurance policy. This method is illustrated in two ways:

1. Surrender of Policy Approach-calculation of the interest rate required for the accumulated value of the total premiums paid (minus any Dividends) into the policy at a given time to equal the Cash Surrender Value of the policy at that time;

2. Death Benefit Paid Approach-calculation of the interest rate required for the accumulated value of the total premiums paid (minus any dividends) into the policy at a given time to equal the death benefit of the policy at that time.

The true annual rate of earnings on an investment. Equates the value of cash returns with cash invested. Considers the application of Compound Interest factors. Requires a trial-and-error method for solution. The formula is

n periodic cash flow

∑ _______________ = investment amount

t - 1 (1 + i)^t

where i = internal rate of return

t = each time interval

n = total time intervals

∑ = summation
Example: Abel sells for $200,000 land that he bought 4 years earlier for $100,000. There were no Carrying Charges or Transaction Costs. The internal rate of return was about 19%. That is the annual rate at which compound interest must be paid for $100,000 to become $200,000 in 4 years.
Example: Baker received $3,000 per year for 5 years on a $10,000 investment. The internal rate of return was about 15%.

Rate earned on a proposal. It is the rate of interest that equates the initial investment (I) with the present value (PV) of future cash inflows. That is, at IRR, I = PV, or NPV (net present value) = 0. Under the internal rate of return method, the decision rule is: accept the project if IRR exceeds the cost of capital; otherwise, reject the proposal.

For example, consider the following data:

Initial investment $16,200

Estimated life 10 years

Annual cash inflows $ 3000

Cost of capital (minimum required of return) 10%

Set up the following equality (I = PV):

$16,200 = $3000 x PV

Then PV = $16,200/$3000 = 5.400, which stands somewhere between 12% and 14% in the 10-year line of table 4 in the back of the book. Because the investment's IRR (13.15%) is greater than the cost of capital (10%), the investment should be accepted.

The IRR method is easy to use as long as cash inflows are even from year to year. Where cash flows are uneven, the IRR must be determined by trial and error. Assume, for example, that a company is considering an investment project that promises cash inflows of $400,000, $600,000, and $1,000,000 for each of the next three years for a given investment of $1,490,000. The IRR is found by selecting a rate and discounting the cash inflows. If the PV is greater than I, select a higher rate until one is found that equates the PV of the cash inflows with I. In this example, the IRR is approximately 14%, determined as follows:

An advantage of the IRR method is that it considers the Time Value of Money and is therefore more exact and realistic than Accounting Rate of Return (ARR). Disadvantages are: (1) it fails to recognize the varying size of investment in competing projects and their respective dollar profitabilities, and (2) in limited cases, where there are multiple reversals in the cash-flow streams, the project could yield more than one internal rate of return.

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