Internal Rate of Return

The internal rate of return is based on discounted cash flows. Unlike the net present value rule, however, it takes into account the project's scale. It is the discounted cash flow analog to the accounting rates of return. Again, in general terms, the internal rate of return is that discount rate that makes the net

Internal Rate of Return (IRR): The IRR of a project measures the rate of return earned by the project based upon cash flows, allowing for the time value of money.

present value of a project equal to zero. To illustrate, consider again the project described at the beginning of the net present value discussion.

Investment <$ 1000>

Internal Rate of Return = 24.89%

At the internal rate of return, the net present value of this project is zero. The linkage between the net present value and the internal rate of return is most visible when the net present value is graphed as a function of the discount rate in a net present value profile. A net present value profile for the project described is illustrated in Figure 5.4.

Figure 5.4: NPV Profile

Figure 5.4: NPV Profile

Npv Profile Graph Images

The net present value profile provides several insights on the project's viability. First, the internal rate of return is clear from the graph - it is the point at which the profile crosses the X axis. Second, it provides a measure of how sensitive the NPV — and, by extension, the project decision -- is to changes in the

NPV Profile: This measures the sensitivity of the net present value to changes in the discount rate. 63

discount rate. The slope of the NPV profile is a measure of the discount rate sensitivity of the project. Third, when mutually exclusive projects are being analyzed, graphing both NPV profiles together provides a measure of the break-even discount rate - the rate at which the decision maker will be indifferent between the two projects.

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