‘Internal Rate of Return (IRR)’ is used by organisations for comparing the returns obtained from internal or in-house projects versus investing the same funds in instruments available outside the organisation. For example suppose a company’s expansion project is projected to yield an average return on investment of 7% over its lifetime, this is called the project’s ‘Internal Rate of Return’ or ‘IRR’.
Suppose by investing the same amount in fixed deposit the organisation can earn 7.25%, then there is no financial sense in undertaking the expansion scheme. After all the expected return of 7% per annum from the expansion idea is just a projection fraught with innumerable execution risks, whereas the 7.25% interest income is certain and risk-free and therefore it makes more economic sense to invest the funds in a guaranteed, risk-free instrument like fixed deposit. Extending the logic further, even if the interest on fixed deposit with a bank is lower than the projected IRR is marginally lower, say 6.50% per annum, still the corporation may most likely decide to take the fixed deposit decision for the simple reason of risk avoidance. Only when the project is expected to generate a significantly higher IRR, say 20-25, compared will a 7% on bond or fixed deposit will a business risk making an investment decision.
So, in simple terms, IRR is the expected rate of return from an in-house project.