Definition of Internal Rate of Return
The internal rate of return is the interest rate that will discount an investment's future cash amounts to be equal to cash paid at the beginning of the investment. In capital budgeting, the internal rate of return results in an investment having a net present value of zero.
The internal rate of return is one of the tools in capital budgeting that considers both of the following:
- The time value of money
- All of the cash payments and cash receipts during the life of the investment
Example of Internal Rate of Return
Assume that a company is considering an investment that will provide net cash inflows of $1,000 at the end of each year for five years. The amount of cash that the company must pay at the beginning of the investment is $3,600. Someone must determine the interest rate that will discount the five $1,000 future cash receipts so that their present value at the time of the investment will equal $3,600. This is best done through software or manually (trial and error). In our example, the internal rate of return is approximately 12%.