Internal rate of return

The internal rate of return (IRR) is a method of calculating rate of return. The term internal refers to the fact that its calculation does not involve external factors, such as inflation or the cost of capital.

It is also called the discounted cash flow rate of return (DCFROR).

In the context of savings and loans, the IRR is also called the effective interest rate.

The internal rate of return on an investment or project is the "annualized effective compounded return rate" or rate of return that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero. Equivalently, it is the discount rate at which the net present value of future cash flows is equal to the initial investment, and it is also the discount rate at which the total present value of costs (negative cash flows) equals the total present value of the benefits (positive cash flows).

Corporations use IRR in capital budgeting to compare the profitability of capital projects in terms of the rate of return. For example, a corporation will compare an investment in a new plant versus an extension of an existing plant based on the IRR of each project. To maximize returns, the higher a project's IRR, the more desirable it is to undertake the project. If all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

The internal rate of return is an indicator of the profitability, efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the net value or magnitude added by making an investment.

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