Definition: Internal rate of return, commonly abbreviated IRR, is used to measure an acceptable level of return for an investment by equating a net present value rate of zero to the investment. In other words, management uses the internal rate of return to develop a baseline or minimum rate that they will accept on any new investments. Then they use this rate to decide what investments the company should make.
What Does IRR Mean?
The internal rate of return is calculated by discounting the present value of future cash flows from the investment with the internal rate of return and subtracting the initial investment amount. The end product of this formula should equal zero.
Since this calculation uses the time value of money, you will either need present value tables or a financial calculator to do any kind of internal rate of return example.
We will just stick to the basics for this definition. Basically, the IRR shows management what they need to receive from any investment in order to make it worthwhile for the business to pursue.
For example, assume that management previously determined that the lowest acceptable rate of return on an investment must be at least 2 percent. During the second quarter, a vendor approached the purchasing manager with a special deal on new machinery. The vendor was willing to reduce the machines by 50 percent of the retail cost. Should the manager buy the machines?
It doesn’t matter how good a deal the vendor is willing to give the manager if he can’t recognize sufficient levels of return on the new equipment. For example, what if the factory already has idle equipment. These new machines will just add to the idle amounts of equipment. The internal rate of return calculates what percentage return the manager must see on the new equipment if he purchases. If he only thinks he can get a 1.5 percent return based on the future cash flows, he shouldn’t buy the equipment.