Internal Rate of Return, usually the abbreviation IRR is used. It is an indicator for relative yield (profitability) that the project provides during its lifecycle.
- IRR… internal rate of return
- CFt… cash flow for each year
- n… project lifetime
Numerically it is equal to the discount rate at which NPV equals zero. For investments with the lifetime exceeding two years, the iterative methods or trial-and-error should be used (for the calculation, the spreadsheets such as MS Excel can be used).
An investment is acceptable under this criterion if the IRR is greater than the discount rate or WACC. The higher the IRR, the higher the return on investment.
IRR can only be used for investments with conventional cash flows, where the sign of financial flows in the individual periods is changed only once. For non-conventional cash flows, where there is a change several times in sign of financial flows in individual periods, the IRR can take multiple values. In case that we have only positive cash flows (e.g. we obtain a grant for the initial investment), the IRR may not exist.
Use of the IRR in practice: In the enterprise it used by CFO in assessing the effectiveness of the investment. The criterion should be used complementary.
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