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The IRR Rule – Internal Rate of Return

 

The underlying principle is the internal rate of return. This rate measures the profitability of potential investments and, therefore, is a good guide for decision-making.

 

Computing the internal rate of return

 

The internal rate of the discounted rate. The first step of the procedure is to discount and add up all future cash flows, then subtracting the total initial costs. The second step is to set this formula equal to zero.

The last step is to solve for the discount rate, as this is the value in which we are actually interested. Solving the equation for the discount rate reveals the internal rate of return for this investment.

The IRR must be lower or equal to the investment´s forecasted yield. The rate an investment at minimum must yield to be worth taken into consideration.

 

In most cases, the formula for the discounted cash flow is too long and complicated so that the discount rate must be computed through trial and error. Using the trial-and-error-procedure can lead to discretion and thus, other methods for investments evaluation should also be used. Nonetheless, the IRR Rule is very often use to pre-select investment for further scrutiny.

 

For any question regarding the IRR Rule or any over finance related topic to not hesitate to approach us.

 

 

WHU Finance Society