Reading: Internal Rate of Return (IRR)

Many investors think in returns rather than dollars earned. Instead of asking by how much an investment decision increases the investor's net worth, as the NPV rule does, we could also try to figure out what return investors can expect to earn when investing in a specific project. That's the idea behind the Internal Rate of Return (IRR). 

This module shows how to compute the IRR of a project and how to make investment decisions based on IRR. It also discusses some challenges that we face when using the IRR to allocate capital. Specifically, the section proceeds as follows:

• We start with a simple example that illustrates the computation of the project return. This example allows us to formulate the IRR Rule and to discuss the relation between IRR and NPV.
   
  
• Second, we summarize the main advantages of the IRR rule, which explain why it is so popular in finance practice.
   
• Third, we show how to compute the IRR for projects with more complex cash flow patterns.
   
• Fourth, we discuss specific challenges we might face when deciding based on the IRR rule.
   
• Finally, we conclude with some recommendations for the use of the IRR in combination with the NPV.