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Financial Dictionary - IRR (Internal Rate of Return)
IRR (Internal Rate of Return)
The internal rate of return applied to investing in financial assets refers to the discount rate that makes the net present value zero for all collections and payments derived from the subscription and possession of assets where the assumption is that these collections and payments will be reinvested or financed, respectively, at the same interest rate as the rate calculated, until maturity. For fixed-income instruments it is similar to the AER for deposits.
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The IRR measures the viability of a project or company and is translated into a percentage of profit or loss. It is used as a supplementary tool to the net present value (NPV). The internal rate of return therefore implies the assumption of an investment opportunity.
How is the IRR calculated?
To calculate the internal rate of return, it is necessary to equal to zero the discount rate at the initial moment and the future flows of collections and payments so that the NPV equals 0.
What is IRR used for?
This rate is one of the criteria or indicators used when deciding whether to reject or accept an investment project. The IRR is compared to a minimum rate or cut-off rate. The investment will be accepted if the return rate is higher than the cut-off rate. Conversely, if the IRR is lower, the investment will be rejected. If it is equal to the cut-off rate, the investment may be carried out as long as it implies an improvement in the competitive position of the company and there are no other favourable alternatives.
Some projects have more than one IRR, in which case it is not possible to calculate a stable IRR. For these more complex situations, the MIRR formula (modified internal rate of return) is used. The difference in this case is that only the cash flows at two specific moments (instead of in multiple periods) are taken into account:
- the initial moment when the total disbursements would be made;
- the final moment when the total collections generated by the project would be received.
In short, the IRR is a very important tool when deciding whether to carry out a project or not since it measures the viability of the project. It's important to bear in mind that the IRR should be accompanied by the use of other means of project evaluation to avoid omitting other aspects that could generate value for the project and are not considered in this calculation.