Understanding Internal rate of return analysis

Internal rate of return (IRR) is another analytical method that can help you or your organization to decide whether to make a particular investment. IRR is the rate at which the NPV of an investment equals zero. Like NPV, IRR enables you to consider returns on an annual basis and takes into account the time value of money.

Typically, when the IRR is greater than the opportunity cost (the expected return on a comparable investment) of the capital required, the organization should make the investment under consideration.

The IRR calculation is based on the same algebraic formula as the NPV calculation. With the NPV calculation, you know the desired rate of return, and you’re solving the equation for the net present value of the future cash flows. With IRR, the NPV is set at zero, and you solve the equation for the rate of return.

Your spreadsheet program, app, or calculator will perform IRR calculations for you, just as it will for NPV.

What’s a reasonable rate of return for a business to expect on an investment comparable to the one under consideration? Typically, it’s well above what it could get on a “risk-free” investment, such as a Treasury bill or note (which is usually the benchmark value).

In many instances, companies will set a hurdle rate, which is the minimum rate of return that all investments are required to achieve. In such instances, the IRR of the investment under consideration must exceed the hurdle rate before the company will go forward with it.

 

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Categories: Personal Finance

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