Corporate financeLesson 2 of 5 in the course How Companies Think about Investing

IRR: Decision Rule, Calculation, and Key Limitations

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

The internal rate of return (IRR) evaluates an investment by finding the discount rate that makes its net present value equal zero. This lesson explains what IRR means, how it supports investment decisions, and how it can be calculated using a financial calculator.

The internal rate of return is the discount rate at which the present value of a project's cash inflows equals the present value of its cash outflows. Equivalently, it is the rate that makes the project's net present value (NPV) equal zero.

All flashcards

Internal rate of return (IRR)
The discount rate that makes a project's NPV equal zero.
Cost of capital
The cost to a company of obtaining funds.
Multiple IRRs
Different discount rates at which a project's NPV can equal zero.
IRR reinvestment assumption
Interim project cash flows are reinvested at the project's IRR.
IRR and project scale
A higher percentage return does not necessarily mean greater total value.

Quiz questions

  1. Which cash-flow pattern can produce more than one IRR?Answer: An initial outflow, a later inflow, and a subsequent outflow.
  2. What reinvestment assumption does the IRR method make about cash flows received during a project?Answer: They are reinvested at the project's IRR.
  3. Why can IRR be misleading when comparing projects of different sizes?Answer: A smaller project can have a higher IRR but create less total value.
  4. How is IRR commonly found by hand?Answer: Try a discount rate, calculate NPV, and adjust the rate until NPV is near zero.
  5. If a project's IRR equals the cost of capital, what is its NPV at that discount rate?Answer: Zero.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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