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Home > QFINANCE Dictionary > Definition of internal rate of return

Definition of

# internal rate of return

Finance

interest rate indicating worthwhile profit in a discounted cash flow calculation, the rate of interest that reduces future income streams to the cost of the investment; practically speaking, the rate that indicates whether or not an investment is worth pursuing.

Let's assume that a project under consideration costs \$7,500 and is expected to return \$2,000 per year for five years, or \$10,000. The IRR calculated for the project would be about 10%. If the cost of borrowing money for the project, or the return on investing the funds elsewhere, is less than 10%, the project is probably worthwhile. If the alternative use of the money will return 10% or more, the project should be rejected, since from a financial perspective it will break even at best.

Typically, managements require an IRR equal to or higher than the cost of capital, depending on relative risk and other factors.

The best way to compute an IRR is by using a spreadsheet (such as Excel) or financial calculator.

If using Excel, for example, select the IRR function. This requires the annual cash flows to be set out in columns and the first part of the IRR formula requires the cell reference range of these cash flows to be entered. Then a guess of the IRR is required. The default is 10%, written 0.1.

If a project has the following expected cash flows, then guessing IRR at 30% returns an accurate IRR of 27%, indicating that if the next best way of investing the money gives a return of -20%, the project should go ahead.

 Now −2,500 Year 1 1,200 Year 2 1,300 Year 3 1,500

IRR can be misleading, especially as significant costs will occur late in the project. The rule of thumb "the higher the IRR the better" does not always apply. For the most thorough analysis of a project's investment potential, some experts urge using both IRR and net present value calculations, and comparing their results.

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Definitions of ’internal rate of return’ and meaning of ’internal rate of return’ are from the book publication, QFINANCE – The Ultimate Resource, © 2009 Bloomsbury Information Ltd. Find definitions for ’internal rate of return’ and other financial terms with our online QFINANCE Financial Dictionary.