Learn what the internal rate of return is and why it is one of the most commonly used formulas for choosing between different investment alternatives.
Explore in depth the importance of calculating the IRR and how this metric becomes a fundamental pillar in strategic financial decision-making.
There are two key points for investors when investing in a project: an executive summary that is attractive to them and an internal rate of return that guarantees the profitability czech republic email list of the project . Companies also use the IRR to know which projects to invest in .
The internal rate of return or profitability (IRR) is also known as the internal rate of return (IRR) for those who use English as their name.
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What is the internal rate of return?
The IRR is an indicator of the profitability of projects or investments , so that the higher the IRR, the higher the profitability. Calculating the internal rate of return for different projects makes it easier to make decisions about the investment to be made.
In simple terms we could define the IRR as the percentage of income or losses obtained as a result of an investment.
This financial concept can be compared to the safe rate of return for investing or the interest used to finance a project.
In the first case, if the IRR exceeds the risk-free rate of return or the opportunity cost , the investment would be made; otherwise, it would be rejected.
In the second case, the IRR must be higher than the interest rate of the project financing . In this case, the internal rate of return would be the maximum interest rate at which a company or investor can borrow to avoid losing money on the investment.
What is the IRR formula?
The IRR is the discount rate at which the net present value (NPV) equals zero or, in other words, the rate that equals the sum of the present value of expenses with the sum of the present value of expected income.
Internal Rate of Return
Interpretation of the IRR result
In the event that own resources are used to carry out the project or investment, the following options may apply.
IRR > 0. The project is acceptable, since its profitability is greater than the minimum required profitability or opportunity cost. This means that if we invested in this project we would earn more money than by acquiring Government Bonds.
IRR < 0. The project is rejected. The reason is that the project yields a return lower than the minimum required return. In this case, it would not make sense to make the investment since we would earn more money by investing in Government Bonds.
IRR = 0. In this case, it would be irrelevant whether to carry out the project, since we neither win nor lose. In situations with values equal to or close to zero, it is necessary to assess whether other types of benefits associated with carrying out the project can be obtained.
If financing is needed to carry out the project , we will have to compare the IRR with the cost of money, which we can call k.
In this case, the net profitability of the project will be the difference between the IRR and the cost of the loan (IRR-k).
If IRR > k . The project is accepted. The return exceeds the cost of the capital that has been lent to us.
If IRR < k . The project is rejected. The profitability of the project would not cover the cost of the loan.
If IRR = k . Other factors would have to be assessed, since neither is there a gain nor a loss.
If we are evaluating two mutually exclusive projects, it is generally better to opt for the one with the higher IRR. However, it is important to consider the risk, duration and initial investment of both projects.
