The internal rate of return (IRR) is a financial metric used to assess the profitability of an investment. The IRR is the rate of return that makes the present value of the investment's future cash flows equal to the investment's initial cost. In other words, it is the discount rate that makes the net present value (NPV) of an investment equal to zero.
The internal rate of return is calculated by discounting the cash flows of an investment at a series of increasing discount rates and finding the rate at which the NPV equals zero. The discount rate that makes the NPV equal to zero is the internal rate of return.
There are several benefits of using the internal rate of return to assess the profitability of an investment. First, the IRR takes into account the time value of money, which is the idea that money is worth more today than it is in the future. Second, the IRR can be used to compare investments with different durations. For example, an investment with a shorter duration may have a higher IRR than an investment with a longer duration, even if the latter investment has a higher absolute return.
There are also several drawbacks of using the internal rate of return to assess the profitability of an investment. First, the IRR assumes that cash flows are reinvested at the IRR, which may not be realistic. Second, the IRR can give rise to multiple rates of return for a single investment, which can be confusing. Finally, the IRR can be sensitive to small changes in cash flows, which can make it difficult to compare investments.
The internal rate of return can be compared to other investment metrics, such as the net present value and the payback period. The NPV is the present value of an investment's future cash flows minus the investment's initial cost. The payback period is the length of time it takes for an investment to generate enough cash flow to cover its initial cost.
There are many real-world examples of the internal rate of return in action. For instance, a company might use the IRR to compare different investment projects and choose the one with the highest IRR.