Internal return rate (IRR)
What is it?
IRR is a key measure for evaluating the profitability of an investment. It represents the discount rate that equates the present value of future cash flows with the initial capital invested. In other words, it determines the rate at which the discounted future revenues equal the amount initially invested in the project.
A higher IRR indicates a higher return on investment, making it a useful tool for comparing different projects or assets. It is applied to various areas, such as real estate projects, venture capital, stocks, and others, where future cash flows are not immediate and must be adjusted to the present value.
Key aspects to consider
This indicator is essential for measuring the economic viability of a project. If the calculated rate is greater than the cost of capital or the discount rate used, the project is potentially profitable. Moreover, IRR allows for the standardized comparison of expected or actual returns across different investment products, regardless of the invested amount or time frame, making it a useful tool for investment decisions.
However, it has certain limitations, such as the possibility of obtaining multiple results in cases where cash flows change sign multiple times, which can complicate its interpretation. It is also important to remember that it does not reflect the absolute size of the investment. A project with a high rate may not be as attractive if it requires significantly more capital compared to other projects with lower rates but smaller initial investment needs.
Therefore, it is recommended to use IRR along with other metrics, such as Net Present Value (NPV), to get a more comprehensive view of the investment’s performance and its ability to generate value.