Internal rate of return
Discount rate at which the net present value of investment project zero; the rate of return of a project over to useful life
The Internal Rate of Return (IRR) is a financial metric used to estimate the potential profitability of an investment over its lifetime. It is the interest rate that makes the net present value of all cash flows from an investment equal to zero.
To calculate the IRR, first, you need to list down all the cash flows that will be incurred in an investment. Then, we need to find a rate at which the present value of all the cash inflows equals the present value of all the cash outflows. The rate obtained through this calculation is known as the internal rate of return.
The IRR is used as a tool to evaluate the feasibility of a potential investment. A higher IRR indicates that an investment is more profitable, while a lower IRR indicates that an investment may not be as profitable. A positive IRR value implies that the investment generates profits whereas a negative IRR value implies a loss in investment.
The IRR can be used to compare multiple investment options and help in the decision-making process. However, it has some potential limitations, such as the fact that it assumes cash flows are reinvested at the same rate, which may not be the case in reality. Additionally, the IRR calculation requires precise inputs, which rely on predictions and assumptions that may not always be accurate.
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