7.14 : Decision-making Through Internal Rate of Return

Internal rate of return or IRR plays a crucial role in decision-making processes, offering a clear benchmark for measuring the profitability of any project or investment.

Consider an electronic manufacturing company's project, having an initial investment of a hundred thousand dollars and expecting to generate annual cash flows of thirty thousand dollars for the next five years.

The company's required rate of return, or RRR, is twelve percent, and the IRR has been calculated at approximately fifteen point two four percent.

The IRR represents the project's expected rate of return based on the projected cash flows. In contrast, RRR represents the minimum acceptable return given the company's risk tolerance and alternative investment opportunities.

The project is expected to generate a return higher than the minimum required by the company.

The company should move forward with the project since the IRR is higher than the RRR.

This method ensures the company undertakes a project to enhance shareholders' value.

When projects have different durations or capital requirements, comparing projects solely on IRR can be misleading.

IRR should be used along with other metrics like NPV and Payback period to make more informed investment decisions.