The discount rate often used in capital
budgeting that makes the net present value
of all cash flows from a particular
project equal to zero. Generally speaking,
the higher a project's internal rate of
return, the more desirable it is to
undertake the project. As such, IRR can be
used to rank several prospective projects a
firm is considering. Assuming all other
factors are equal among the various
projects, the project with the highest IRR
would probably be considered the best and
undertaken first.
IRR is sometimes referred to
as "economic rate of return (ERR)".
You can think of IRR as the rate of
growth a project is expected to generate.
While the actual rate of return that a given
project ends up generating will often differ
from its estimated IRR rate, a project with
a substantially higher IRR value than other
available options would still provide a much
better chance of strong growth.
IRRs can also be compared against
prevailing rates of return in the securities
market. If a firm can't find any projects
with IRRs greater than the returns that can
be generated in the financial markets, it
may simply choose to invest its retained
earnings into the market.
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