IRR Definition (Internal Rate of Return) | Finance Strategists | Your Online Finance Dictionary

hi i'm rainey with finance strategist in this lesson we're going to cover [Music] internal rate of return or irr is the rate of return at which a project breaks even and is used by management to evaluate potential investments irr functions as a return on investment or roi calculation to understand irr one must understand net present value or npv net present value is calculated by discounting future cash flows by a discount rate which is the rate a company expects to earn on investments if a project offers 1 000 for 3 years the present value of future cash flows is not worth three thousand dollars to the company because it has an expectation that its money should earn more money over time this concept is known as the time value of money or tvm if a company invests two thousand dollars into a project which offers one thousand dollars for three years at an eight percent discount rate the present value of future cash flows is two thousand five hundred and forty five dollars and nine cents after subtracting the initial investment the net present value of the project is 545 dollars and nine cents suggesting this is a good investment at the current discount rate the internal rate of return is the discount rate that would bring this project to break even or zero dollars net present value in this case an internal rate of return of 18.95 brings the net present value of future cash flows to zero a company's discount rate is typically derived from its cost of capital or the cost a company pays investors in exchange for capital either in interest from issued debt or through selling equity in the company the weighted average cost of capital often functions as a company's hurdle rate or the minimum required rate of return because the irr in our example exceeds the discount rate or required rate of return the irr rule says that management should invest in this project it's important to note that certain assumptions can cause the irr to become overstated for this reason many investors use the modified internal rate of return or mirr which account for these assumptions [Music] let's hear from you should management always invest in a project if the project's irr exceeds the company's required rate of return leave a comment below [Music] for more information visit finance strategists strategies for you

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