Overview
Is the question “What is internal rate of return (IRR)?” baffling you? Well, it is the expected growth rate of a project investment. It is comparable with the rate of return obtained through investment of money in other projects. Basically, organizations calculate IRR to taken decision between several investment alternatives. The greater the IRR, the more acceptable project is. Project managers use the IRR to calculate the profitability of a project. It is calculated as a discount rate that makes the net present value of a cash flow of a project equal to zero. It is expressed in terms of percentage and helps one to determine the potential return on project investment.
How to Calculate IRR in Project Management?
IRR formula and calculation example:
Suppose you are a project manager and there are two project investments before you. You choose one of the projects based on its prospective returns. In order to do this, you need to take a glance at five year cash flow of each project. Let the two projects be A and B. Now, calculate the Internal Rate of Return for each project to know which is better for you.The Internal Rate of Return rate zeroes all cash flows’ Net Present Value. At this rate of return, future cash inflows match the present value of initial investment.
Project A has 12% Internal Rate of Return and Project B has 15%. Now, do comparison of these rates to the cost of capital of your company. If the cost of capital of your company is 10%, both projects yield better returns. Project B has a higher Internal Rate of Return i.e. 15% than Project A, i.e. 12%, so you might make up your mind to choose it. If all other things are equal, a higher Internal Rate of Return makes the investment better and more appealing.
Remember that there is great importance of IRR in investment decisions. IRR is also used with other financial measures to assess the profitability and risk of the project.
Benefits of Internal Rate of Return
• Internal Rate of Return sets a benchmark for decision-making• Internal Rate of Return is easy to understand and communicate
• Internal Rate of Return makes the comparison of projects easier, which helps you choose projects and allocate funds to those having better returns.
• You can use Internal Rate of Return for the evaluation of long-term investment projects in capital planning to allocate resources efficiently.
• Project managers understand the fluctuations of cash flow with Internal Rate of Return, which analyzes amount and timing.
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