Internal rate of return (IRR) definition
/What is the Internal Rate of Return?
The internal rate of return (IRR) is used to calculate the projected profitability of a proposed investment. It 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. A proposed investment with a high IRR is usually considered a desirable use of funds.
When to Use the Internal Rate of Return
IRR 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.
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When Not to Use the Internal Rate of Return
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).
Disadvantages of the Internal Rate of Return
The internal rate of return calculation does not factor in the impact of any spikes or dips in the cash flows going into the calculation; instead, it assumes a steady rate of cash flow, which is rarely the case in reality. In addition, the calculation assumes that any positive cash flows generated by an investment will be reinvested at the same internal rate of return - which is quite likely not going to be the case. In short, the calculation is not sufficiently precise to generate an accurate rate of return figure, given the realities of cash flows and investment rates.