Definition: The Internal Rate of Return or IRR is a rate that makes the net present value of any project equal to zero. In other words, the interest rate that equates the present value of cash inflow with the present value of cash outflow of any project is called as Internal Rate of Return.
Unlike the Net present value method where we assume that the discount rate is known, in the case of Internal rate of return method, we put the value of NPV zero and then find out the discount rate that satisfies this condition.
The formula to calculate IRR is:
CFo = n∑t=1 Ct / (1+r)t
Where, CFo = Investment
Ct = Cash flow at the end of year t
r = internal rate of return
n= life of the project
Accept- Reject criteria: If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal.
Merits of Internal Rate of Return
- IRR takes into account the Time Value of Money.
- It considers the cash flows over the entire life of the project.
- IRR is consistent with the goal of wealth maximization.
- While computing the NPV the discount rate taken is normally the cost of capital, but in the case of IRR, there is no need for the cost of capital because the rate of return generated by the project itself is used to evaluate the efficiency of the project. Thus, the rate is internal to the project.
Demerits of Internal Rate of Return
- It is quite difficult and involves tedious calculations.
- IRR produces multiple discount rates, which might be confusing.
- While evaluating the mutually exclusive proposals, the project having the highest value is chosen over the other that may not be necessarily the most profitable or be in line with the objectives of the firm of wealth maximization.
- It is assumed that the cash flows are reinvested at an internal rate of return.
The internal rate of return is usually the rate of return that a project earns. It is often called as the yield on investment, the marginal efficiency of capital, the marginal productivity of capital, rate of return and time adjusted rate of return.