Before we delve into this, we need to see what “Rate of Return” means (no “internal” yet). The rate of return is the “speed” with which you earn money back annually, every year, forever, compared to the amount you initially invested. So that it can be compared to the largest amount invested, it is written as a percentage (%). For example, if you invest $100 and earn $3 per year forever, then the “rate of return” is 3%. Easy, right?
Now let’s change the problem a bit. What if, with the same $100 investment above, you’ll make money for a few years…and not all in the same amounts each year? What if the money coming in could stop after a certain number of years? For example, you’ll get $5 in the first year, maybe $8 in the second year, $3 in the third year, and $95 in the fourth year (which could also be the last year… so it’s not forever). What is the rate of return now? As you can see, in the latter case, it is not so easy to get the percentage rate. This is because it is not as simple as the first example above, since the annual cash flow is not a constant amount (like the $3 in the first example above) and it is not forever.
This percentage in the latter case is now called the Internal Rate of Return. Since it is not easy to get the percentage, we can say that it is like a “hidden” percentage… hence the term “internal”… because the word “internal” is like a formal way of saying “hidden”.
How is this concept useful? If the IRR of your project or business venture is lower than the cost of debt or the amount of interest rate you would pay to a bank (if you borrow money from the bank to carry out the investment or project), then it is not a good choice. investment. Why? Of course! Because if you pay 3% to the bank to do a project or make an investment, and then earn an IRR of only 2%, then you lose 1%.
On the other hand, if your IRR or Internal Rate of Return is higher than the amount you would borrow from the bank to pay for an investment or project, then it is a good investment, due to the positive “spread” between your rate of return and cost of investment. Debt. Similarly, if your IRR is the same as the interest rate you would pay the bank, then you are at breakeven.
This, in a nutshell, is a simplified explanation of the IRR. Note that in more complex problems, you can compare your internal rate of return not only to the cost of debt, but also to the cost of capital or the weighted average cost of capital, or WACC.
