Sunday, August 7, 2016

What Is Internal Rate of Return or IRR In Simple Terms?

‘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.