What is IRR (Internal Rate of Return) and How to Use It to Evaluate Investments?

A Comprehensive Guide to Understanding and Applying the Internal Rate of Return in Financial Project Evaluations

IRR Image by author via Copilot of OpenIA

The IRR (Internal Rate of Return) is an essential financial tool used to evaluate the profitability of an investment or project. In this article, we will explain what IRR is, how it is calculated, and provide three practical examples to illustrate its use.

What is IRR?

The IRR is the discount rate that makes the net present value (NPV) of the future cash flows of an investment equal to zero. In other words, it is the interest rate at which the present value of expected revenues from an investment equals the present value of the costs of the investment. Mathematically, it is determined by solving the following equation:

where:

• NPV is the net present value.
• Ct is the cash flow at period t.
• n is the total number of periods.
• IRR is the internal rate of return.

Interpreting IRR

• Comparison with the cost of capital: If a project’s IRR is greater than the cost of capital (or the minimum…