Internal Rate of Return

Overview of Internal Rate of Return
Internal rate of return is one of the various capital budgeting methods. This method is employed on a wide scale. The main users of the internal rate of return are the business entities. The internal rate of return assists these companies to take decisions regarding investments.

Description of Internal Rate of Return
The internal rate of return normally provides an evaluation of the effectiveness of the investments that are made by companies. It is different from other forms of capital budgeting techniques like net present value for example.

Unlike the internal rate of return the net present value is normally used in order to measure the worth of a particular business undertaking. The internal rate return is also known as IRR. The internal rate of return is normally obtained from the yield that could be received from investments. The internal rate of return is normally calculated on a yearly basis. It could be described as a combined and effective rate of return. The internal rate of return could also be equated with a substitute cost of capital. It also includes a premium for risk that is supposed to be proper.
Assumptions of Internal Rate of Return
In some cases the rate of return, which may be obtained by putting money in financial instruments like bonds, opening accounts in banks or other investments is less than the internal rate of return of an investment. In such cases the particular investment would be considered to be profitable.

Provided the cost of capital of a certain business undertaking is lesser than the internal rate of return of the same, it is assumed that the particular project would make value addition to the company.

Mathematical Definition of Internal Rate of Return
As per mathematical terms the internal rate of return is often explained as a rate of discount, which leads to a sequence of cash flows that have a net present value, which is equal to zero.
Mathematical Representation of Internal Rate of Return
Following is a numerical presentation of the internal rate of return:

NPV = 0 = Initial Investment + ? Nt=1Ct/(1 + IRR)t

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Last Updated on : 27th June 2013