The Internal Rate of Return (IRR) method of investment appraisal identifies whether a business project could make money. It is a discount rate that calculates net present value (NPV) as zero In this context, a discount rate is what a company pays for capital after making an adjustment to allow for an investment project's risk. NPV is the current value of an investment's cash inflows minus cash outflows.
Companies compare the profitability of potential projects before making investment decisions. The IRR method of investment appraisal helps with these comparisons by providing percentage rates of return for each project. Managers within companies favour this type of straightforward analysis. Companies also use benchmarks that represent acceptable percentage rates of return from investments. When an IRR is greater than a benchmark figure, the relevant investment could be worthwhile.
A further advantage of the IRR method of investment appraisal is that it considers the time value of money. This refers to the principle that a sum of money a company invests in the present has a greater value than the same sum in the future. The basis of the principle is the profit a current investment could bring in the future. Using the time value of money creates confidence among investors in anticipated cash flow and the outcome of investments.
The IRR method of investment appraisal relies on two assumptions -- that a company reinvests intermediate net cash inflows at the same rate of return as the IRR and that the cost of finance for the investment project is the same as the IRR. In reality, the interest rates for reinvesting net cash inflows and for the cost of finance are likely to change over an investment's lifespan. If so, the IRR could change and affect the project's investment potential.
Calculating NPV to zero for the IRR method of investment appraisal is time-consuming. A company could apply the mathematical procedure repeatedly before arriving at the correct figure. The IRR method also relies on percentage rates of return without accounting for project scale and overall profit. For example, a small project could have a high percentage rate of return but deliver a modest profit. A large project could have a lower percentage rate of return than a small project but generate a greater profit.