What does the internal rate of return measure?

The internal rate of return measures profitability of a certain project or business, it also allows comparing it with that of other projects in order to know what would be a better investment for the company and its shareholders.

The higher the IRR, the more likely it should be to carry out such a project.

To carry out this feasibility analysis, said IRR must be compared with a minimum cut-off rate, which represents the opportunity cost. A simple comparison can be made and according to it it is determined whether the project is feasible to carry out or not.

What is the internal rate of return?

When inquiring into the concept of the Internal Rate of Return (IRR), it is common to find the concept that says that it is the discount rate that makes the Net Present Value (NPV) equal to 0. So those who are not experts on the subject are left blank, because although that definition is mathematically correct, financially it does not say much, to say nothing.

Leaving aside the mathematical talent of the term in question, the internal rate of return is the average annual rate of return that a project it leaves the investors to invest their funds in it and is comparable against the expectations of what was at least desired to obtain when investing.

In this sense, the Internal Rate of Return allows the entrepreneur to know the viability of investing in a specific business or to consider some other options of less risk to invest.

The term internal refers to the fact that external factors, such as inflation, interest rates, etc., are not taken into account for its calculation.

How the internal rate of return is calculated

First you have to know the calculation of the (NPV) Net Present Value, which assumes the cash flows, that is, the income minus the net expenses, deducting the interest rate that was expected to be obtained, less the initial investment.

Any profit that is greater than zero will be in favor of the company in relation to the investment with less risk. In other words, if the NPV result is greater than zero "0" it is well worth making an investment in this project, as it brings a greater benefit.

Net Present Value Formula

Internal Rate of Return Formula

Perform the same calculation, take the NPV to zero, the result of this equation is a percentage, which must be compared with the safest defined interest percentage.

If IRR> r If the rate of return is greater than the opportunity cost, the project is rejected.

If IRR

When to use IRR?

Let's suppose that a company has the opportunity to invest in a new project, for which its bank offers a loan with 5% interest. Under this circumstance, it calculates the IRR of the business obtaining 8.7% as a result with which it decides to invest, since it will obtain a higher profitability.

For example:

An investment project of 100 euros delivers 133 euros in cash for the next two years and 170 euros the third year.

It was determined that the WACC of the project is 9.50%, it means that this is the minimum to be exceeded, after that it creates value for the shareholder, less than that generates loss.

Solving the equation easily with Excel, the IRR is equal to 125%, then after completing the mathematics, the financial one is analyzed.

That 125% is the rate of return, the average that the project generates annually for the investment.

From the IRR point of view, it is easy to capture the project measure, since the minimum that these investors need for this project, as a yield is 9.50% per annum of return very favorable.

Importance and benefits of the Internal Rate of Return

The IRR converts the cost effectiveness obtained by the company in a rate or percentage of profitability, comparable to profitability rates of low-risk investments, in order to really know the most profitable alternative. It is convenient to invest in the one with the highest profitability and lowest risk.

Therefore, it is considered a percentage used to measure the viability of a company or project, which determines the profitability of actual collections and payments generated by the investment.

Becoming a useful tool, capable of generating a quantitative value to know if a certain business or project is viable, feasible or not.

The benefits provided by the Calculation of the Internal Rate of Return (IRR) are:

• Information focused on the net cash flows of the project.
• It is adjusted to the real value of the monetary unit and can be compared with the minimum rate of acceptance of the return, the discount rate, the opportunity rate, or the rate of cost of capital.
• Maximize the profitability of the business or project to be executed.
• It is very useful when analyzing investment projects as it provides the profitability of the future investment.

In summary, the IRR represents an important tool in decision-making when carrying out a new project or business, since it agrees to weigh various profitability options and thus determine if the project is viable or not.