The internal rate of return (IRR) is a financial metric used to estimate the profitability of potential investments. It is the discount rate at which the net present value (NPV) of a project or investment equals zero. In other words, it is the expected compound annual rate of growth that an investment is expected to generate. The IRR is calculated using the same concept as net present value (NPV), except it sets the NPV equal to zero. The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.
The internal rate of return is widely used in analyzing investments for private equity and venture capital, which involves multiple cash investments over the life of a business and a cash flow at the end through an IPO or sale of the business. It is also used to compare the future value of an investment as if it were valued in todays dollars. Many investors prefer to calculate the internal rate of return because it includes several factors ROI does not. When calculating IRR for an investment, an investor is estimating the rate of return after accounting for its projected cash flow and with the time value of money. If an investor has a few options to consider when investing, they can calculate each opportunity’s IRR. Choosing the investment with the highest IRR would likely provide a better return.
It is important to note that in certain circumstances, there can be more than one internal rate of return that makes net present value equal to zero. When this happens, there is no definitive answer to the question "What is the rate of return?". This may occur when the cash flows of the investment are unconventional, i.e. when the sign of the cash flows changes more than once. Modified Internal Rate of Return (MIRR) considers cost of capital, and is intended to provide a better indication of a project's probable return. It applies a discount rate for borrowing cash, and the IRR is calculated for the investment cash flows.
