The concept of internal rate of return (IRR)

1. The concept of internal rate of return

Internal rate of return (IRR) refers to the rate of return that can actually be achieved by project investment. In essence, it is the discount rate that causes the project's net present value to equal zero. That is, taking into account the time value, the present value of the cash flow generated by an investment in the future is exactly equal to the rate of return at the cost of the investment.

The internal rate of return is a basic indicator that reflects the economic effects of a project. It refers to the discount rate when the cumulative present value of net cash flows in each year of an investment project is equal to zero during the construction and production service period. This analysis method takes into account the time value of money and can measure the profitability of each plan, so it is one of the important methods for investment forecast analysis.

2. Application scope of internal rate of return

At present, investment methods such as stocks, funds, gold, real estate, infrastructure, and futures have been familiar and used by many financial managers. However, many people's understanding of the effectiveness of investment is limited to the absolute amount of income, lacking scientific basis for judgment. For them, the internal rate of return (IRR) indicator is an indispensable tool.

Extended information:

The actual meaning of internal rate of return

Internal rate of return is a macro concept indicator. The most popular understanding is the currency that the project investment income can bear. The ability to depreciate and inflate. For example, an internal rate of return of 10% means that the project can withstand a maximum currency depreciation of 10% or inflation of 10% each year during operation.

At the same time, the internal rate of return also indicates the ability to resist risks during the project operation. For example, an internal rate of return of 10% means that the maximum risk that the project can withstand every year during the operation is 10%. In addition, if a loan is required for project operation, the internal rate of return can represent the maximum affordable interest rate. If loan interest is included in the project economic calculation, it represents the maximum increase in loan interest during future project operations.

For example, if the internal rate of return is based on 8%, and inflation is assumed to be around 8%. If it is equal to 8%, it means that when the project operation is completed, no money will be made except the "salary" earned by "oneself", but it is still feasible. If it is lower than 8%, it means that there is a high possibility of losing money when the project operation is completed.

Because of inflation, the money you earn in the future may not be able to cover the cost of your investment now. Projects with long payback periods are particularly important for the internal rate of return indicator. For example, the general investment recovery period for hotel construction is about 10-15 years, and the investment and operation period for large-scale tourism development is more than 50 years. This is the most popular and practical meaning of internal rate of return.

Reference: Internal rate of return-Baidu Encyclopedia