The internal rate of return or IRR is a way to measure and project the expected rate of return on an investment into the future. The internal rate of return is when an investor or business quantifies the current return on investment and uses that date to estimate the annual rate of return that can be expected in the future on an asset. The IRR is not the actual investment return achieved historically in the past it is a forecast of what is possible for an investment looking forward in the future. The IRR takes both past performance into consideration along with its future potential for performance. The word internal is used because when calculating and forecasting the rate of return it excludes any external factors like risk-free interest rate, the impact of inflation, currency risk, the cost of capital that is allocated, and the financial risks.
The internal rate of return was created to quantify the time preference of both money and also investments. A potential return on an investment generated at a specific time is of more value than an identical return received over a longer period of time at a later date. The later return would yield less IRR than the earlier with all factors the same for both investments.
A fixed return on an investment in which capital is deposited one time and the returns on this investment is paid to the investor at one rate every month with the initial capital not increasing or decreasing, would have an IRR the same as the specified rate of return. Another investment which has the same returns on capital as the first investment, but delays the returns for one or more months has a lower IRR due to frequency of compounding returns.
Here is the internal rate of return formula:
0 = CFo + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 +…+ CFn/(1+IRR)n
Where:
- CFo = initial investment outlay.
- CF1, CF2, CF3 …CFn = Cash Flows
- n = Each period
- IRR = Internal rate of return.
Internal rate of return is the annualized rate of growth an investment is projected to create..
Internal rate of return is a good tool for businesses analyzing capital expenditure budgeting for projects to quantify and do a comparison for forecasted rates of annual returns in the future.
Internal rate of return is also at times called the discounted cash flow rate of return.
