Internal rate of return

Also known as: Internal interest rate method, internal interest rate method, IZF method

The internal rate of return is a method of dynamic investment calculation, which aims to compare and evaluate different investment alternatives.

Definition / explanation

The internal rate of return method is intended to help you better assess individual assets with the help of a certain interest rate. The internal rate of return method is used to calculate average annual returns on planned investments or capital investments that generate fluctuating income.

This calculation method uses a discount factor known as the internal rate of return. The internal rate of return indicates the value at which the net present value of the investment is zero. The investment is considered economical if the return is greater than the interest on capital including the risk premium.

How is the internal rate of return calculated?

The calculation of the internal rate of return is divided into several steps. First, two estimated values for the internal rate of return are determined and then the capital values for the two interest rates are calculated.

It is important that one of these net present values be positive and the other negative. The internal rate of return is now calculated from the calculated capital values and the estimated interest rates. The so-called interpolation method is usually used to calculate the interest rate.

• internal rate of return method is used in many companies
• with the help of a few modifications, the internal rate of return method is able to produce useful results
• Individual investments can be assessed well with this method

• the internal rate of return method is unsuitable for comparing investment plans of different amounts with one another
• the informative value of the values calculated using this method is only limited
• The internal rate of return method is not suitable as the sole decision criterion for various investment alternatives

Summary

• The aim is to compare and evaluate different investment alternatives
• internal rate of return indicates the value at which the net present value of the investment is zero
• internal rate of return method has advantages, but also some disadvantages in practical application
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