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MANAGEMENT AND ACCOUNTING WEB |
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Relationship Between the Internal Rate of
Return Note by James R. Martin |
Traditional cash flow analysis (payback) and the accounting rate of return (ROI) fail to consider the time value of money. The internal rate of return (IRR) considers the time value of money and is frequently referred to as the time adjusted rate of return. The IRR is defined as the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows in a capital budgeting analysis, where all future cash flows are discounted to determine their present values. The relationships are presented below. The cost of capital represents the minimum desired rate of return (i.e., a weighted average cost of debt and equity capital). The net present value (NPV) is the difference between the present values of the expected cash inflows and cash outflows.
| IF | Then | Capital Budgeting Decision |
| NPV < 0 | IRR < Cost of Capital | Reject the investment from the cash flow perspective. Other factors could be important. |
| NPV = 0 | IRR = Cost of Capital | Provides the minimum return. Probably reject from the cash flow perspective. Others factors could be important. |
| NPV > 0 | IRR > Cost of Capital | Screen in for further analysis. Other investments may provide better returns and capital should be rationed, i.e., go to the most profitable projects. Others factors could be important. |
