Internal rate of return (IRR)

The internal rate of return is the rate of return at which the present value of a series of future cash flows equals the present value of all associated costs. This measure is commonly used in capital budgeting, where the IRR of a proposed investment should be higher than an entity's cost of capital before the investment will be accepted.

If the IRR for the cash flows associated with a proposed project is unusually high, then it is reasonable to invest in the project, subject to the availability of a sufficient amount of cash. Conversely, if a business cannot locate any projects with an IRR higher than the rates to be earned on investment-grade securities, then a reasonable alternative is to invest excess cash in the securities until better internal projects can be devised.

The IRR is not applicable when a business is forced to make an investment for safety or legal reasons, in which case no rate of return at all is acceptable.

This analysis method provides no guidance on which project to select when there are two or more proposed projects having identical rates of return. In this situation, other analysis methods must be used. This method also provides no guidance when deciding whether to invest in the bottleneck operations of an entity (known as constraint analysis).