The internal rate of return (IRR) is a financial metric used to evaluate the potential profitability of an investment or project. It represents the discount rate at which the net present value (NPV) of all cash flows associated with the investment becomes zero. In simpler terms, IRR is the rate at which an investment breaks even in terms of its initial outlay and future cash flows.
If the calculated IRR is higher than the required rate of return (or the cost of capital), it implies that the investment is expected to generate a return higher than the minimum acceptable level, which is typically viewed as favourable. Conversely, if the IRR is lower than the required rate of return, it suggests that the investment may not meet the minimum required threshold for profitability.
IRR does not explicitly account for the risk associated with an investment. It is important to conduct sensitivity analysis to assess how changes in assumptions or cash flow estimates impact the IRR.
IRR can be used to compare the potential returns of different investment opportunities. When comparing projects, the one with the highest IRR may be preferred, provided it aligns with the company’s risk tolerance.
IRR does not account for the opportunity cost of funds tied up in the investment. This can be a significant factor in decision-making.