An Internal Rate of Return (IRR) is one of the most popular metrics used to measure the profitability of potential investments. The IRR is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. An IRR takes into account the time value of money, analysing an investment project by comparing the internal rate of return to the minimum required rate of return.
Generally speaking, the higher an internal rate of return, or the IRR of a new project exceeds a company's required rate of return, the more desirable it is to undertake the project.
Breaking down an Internal Rate of Return (IRR)
An IRR can be viewed as the rate of growth a project is expected to generate. A project with an estimated higher IRR than other available options will provide a much better chance of strong growth than those with an estimated lower IRR.
The IRR allows project owners and property groups to rank projects by overall rates of return rather than their net present values. An IRR can also be compared against prevailing rates of return in the securities market.
Return on Investment (ROI) vs Internal Rate of Return (IRR)
Internal rate of return (IRR) and Return on Investment (ROI) are two common metrics used to show how an investment has performed over time. Although similar, there two metrics describe investment performance in different terms. An ROI tells an Investor about the total growth, start to finish, of the investment, while an IRR tells the Investor what the annual growth rate is.
ROI describes the percentage gain or loss from an investment over any period of time, and works for any time period (simply being a reflection of the change from one point of time to another).
The IRR calculates the percentage return on an annualised basis regardless of the actual investment period. Whether your investment is for 1 year, 3 years or 20 years, the IRR will tell you the annualised percentage returns of that investment over any period of time.
Both ROI and IRR are useful in their own ways. For monitoring investment performance over the long term, the IRR is more informative because it describes performance in consistent, annual terms. For determining short term gains, the ROI number is the most informative (and a simpler calculation, too!).
"Any advice provided on this blog is general in nature. Readers are urged to seek their own professional advice before making decisions."