Internal Rate of Return (IRR)
Definition of 'Internal Rate of Return (IRR)'
IRR stands for internal rate of return, the discount rate at which the current value of cash flow (also known as the net present value, or NPV) equals zero. In other words, IRR is a way of measuring the profitability of investment in a capital project and the higher the IRR, the more desirable the project will likely be.
TheStreet Explains ‘Internal Rate of Return (IRR)’
When you make an investment in a real asset such as real estate or a company, you want to make to make sure that the cash flow down the line will at the very least return your initial investment. For the investor, it is favorable to identify a relatively high IRR because when an IRR is greater than the initial investment, then the investment is seen as relatively sound. The actual rate of return will, in all likelihood, differ from the IRR, yet a high IRR usually indicates a better than average chance of strong growth.
For example, if a car company is weighing the relative value of building a new assembly plant in the Guangdong Province of China or renovating an existing plant in Detroit, Michigan, it will use IRR as one way to establish the better of the two options. If the possibility of renovating an 80 year-old building in Detroit includes the costly bio-remediation of an adjacent brown field, then the cost of capital to renovate that building may be greater than the IRR. What the company would pay, in other words, would exceed what it would get back. And, if the situation is flipped in Guangdong Province—and the cost of capital is lower than the IRR—then the case for building a new plant in China versus renovating an existing building in the U.S. will seem fairly cut-and-dried.