What is IRR?
IRR stands for internal rate of return and is used mainly for the budgeting of capital, because it can be a tool for measuring and making comparisons of the profitability of projects or investments. The IRR is also known as the rate of return (ROR) or the discounted cash flow rate of return (DCFROR).
IRR refers to the interest rate at which the negative cash flows are equal to the positive cash flows of a particular investment. The negative cash flows refer to the net present value of the costs, while the positive cash flows are the net present value of the benefits.
One of the most common uses of internal rate of return is in the evaluation of the efficiency, yield, and desirability of a project or investment. The higher the IRR of the investment, the more advantageous it is to commence the project. For instance, if all the projects need a similar amount of upfront, the one which has the highest IRR is considered as the most desirable one and must be started first.
A project or investment can be regarded as acceptable if the IRR is higher than the cost of capital. If the internal rate of return of an investment exceeds the cost of capital, it is considered as economically profitable and increases the value of the company.
Corporations also make use of the IRR in order to make comparisons between capital projects. For instance, a company can assess their investment in a new factory and in an extension of an existing factory by looking into the IRR of each. The project which has a higher IRR is then considered to be the better investment.
Lastly, the internal rate of return is also used in the evaluation of stock buyback programs of corporations. Obviously, if a particular corporation allots a huge amount to a stock buyback, it will appear that the corporation’s own stock is a wiser investment compared to other usage of budget for other projects.