Simple Economics on the Web

 Your handy guide to economics


Internal Rate of Return (IRR)

A basic criteria for a good investment is that it have a positive Net Present Value (see the previous page on Net Present Value). A second, related criteria is that the investment have an Internal Rate of Return that exceeds the economy’s rate of interest, r.

The Internal Rate of Return is the rate of interest than an investment pays on your money. As a consequence, if we calculate an investment’s Net Present Value using its Internal Rate of Return as the interest rate, the investment will just break even – that is, its Net Present Value = 0. 

When we calculate an investment’s Net Present Value using the economy’s rate of interest, r, the investment’s Net Present Value will be positive only if the rate of interest it pays you – its Internal Rate of Return – is larger than the economy’s rate of interest.

Below, we have expanded the Net Present Value calculator of the previous page to include a calculation of an investment’s Internal Rate of Return. The diagram shows the Net Present Value of the investment you have entered using different interest rates. The interest rate that causes the investment’s Net Present Value to be zero is the investment’s Internal Rate of Return.

Using the investment numbers in the table, substitute the Internal Rate of Return for the interest rate used to calculate the Net Present Value. Observe the Net Present Value when this new interest rate is used. Then experiment with your own investment project and economy rate of interest to explore the relationship between an investment’s Net Present Value, its President Discounted Value and the economy’s rate of interest.

 

Created by Frank Levy and Myounggu Kang
Last Updated on September 26, 2003