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Internal rates of return are discount rates that are utilized in the process of capital budgeting. Sometimes referred to as an economic rate of return, the internal rate of return, or IRR, identifies the net present value of the flow of cash associated with a specific project. The idea is to determine if the project’s anticipated rate of return is sufficient to make proceeding with the effort worthwhile, of if the project should be abandoned in favor of some other approach or process.
Businesses often calculate the internal rate of return when considering the merits of several different potential projects. The process normally begins by establishing a benchmark of return that is considered equitable for the costs involved. To determine the benchmark, it is not unusual for the business to look at the current rate of return in a securities market, identifying what amount of return could be reasonably anticipated if the assets needed for the project were invested in the market instead.
After the benchmark is in place, the company looks closely at the internal rate of return that is likely to be generated by each proposed project. That return is compared not only to the benchmark, but to the IRR associated with each project currently under consideration. The idea is to identify the project that has the highest potential return, hopefully one that exceeds the benchmark and also amounts to a desirable amount of profit for the business. Typically, the project with the highest predicted internal rate of return will be selected, and the other options placed in a holding pattern until the selected project is completed.
It is important to note that while calculating the internal rate of return for competing projects is an important aspect of deciding which projects are viable and which ones are not, the IRR may not be the only deciding factor. Business owners may also consider benefits other than profit that may be achieved by pursuing a given project, and find them to be sufficient reason to go with a project that provides a lower return in profits, but creates other benefits that have a long term positive effect on the company. For this reason, the internal rate of return is only one tool that is used to decide if a given project is in the best interests of a business, rather than the sole means of assessing the outcome of implementing the project.