A:

In capital budgeting, projects are often evaluated by comparing the internal rate of return (IRR) on a project to the hurdle rate, or minimum acceptable rate of return (MARR). Under this approach, if the IRR is equal to or greater than the hurdle rate, the project is likely to be approved. If it is not, the project is typically rejected.

The hurdle rate is the minimum rate that the company or manager expects to earn when investing in a project. The IRR, on the other hand, is the interest rate at which the net present value (NPV) of all cash flows, both positive and negative, from a project is equal to zero.

Projects are also evaluated by discounting future cash flows to the present by the hurdle rate in order to calculate the NPV, which represents the difference between the present value of cash inflows and the present value of cash outflows.

Generally, the hurdle rate is equal to the company's costs of capital, which is a combination of the cost of equity and the cost of debt. Managers typically raise the hurdle rate for riskier projects or when the company is comparing multiple investment opportunities.

IRR is also used by financial professionals to compute the expected returns on stocks or other investments, such as the yield to maturity on bonds.

While it is relatively straightforward to evaluate projects by comparing the IRR to the MARR, this approach has certain limitations as an investing strategy. For example, it looks only at the rate of return, as opposed to the size of the return. A $2 investment returning $20 would have a much higher rate of return than a $2 million investment returning $4 million to a company.

IRR can only be used when looking at projects and investments that have an initial cash outflow followed by one or more inflows. Also, this method does not consider the possibility that various projects might have different durations.

RELATED FAQS
  1. How do you calculate IRR in Excel?

    Understand how to calculate the internal rate of return (IRR) in Excel and how it's used to determine anticipated yield per ... Read Answer >>
  2. How do you use discounted cash flow to calculate a capital budget?

    Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >>
  3. What's the difference between weighted average cost of capital (WACC) and internal ...

    Both weighted average cost of capital (WACC) and internal rate of return (IRR) are great measures for assessing value, but ... Read Answer >>
  4. How do I use Excel to get discount rate over time?

    Learn how to calculate discount rate in Microsoft Excel and how to find the discount factor over a specified number of years. Read Answer >>
  5. Present Value vs Internal Rate of Return

    NPV and IRR are popular ways to measure the return of an investment project. Learn how net present value and internal rate ... Read Answer >>
  6. What are the main differences between compound annual growth rate (CAGR) and internal ...

    The compound annual growth rate (CAGR), measures the return on an investment over a certain period of time. The internal ... Read Answer >>
Related Articles
  1. Investing

    Internal rate of return: An inside look

    The internal rate of return can be used to measure an compare capital projects, stock buyback programs, and investments to determine which will yield the most favorable return.
  2. Small Business

    Calculating IRR with Excel

    Find out how to calculate the internal rate of return on investments using Microsoft Excel, as illustrated in different investment scenarios.
  3. Investing

    Internal Rate of Return Formula for Excel

    The internal rate of return, or IRR, is a popular metric businesses use to measure a project’s return on investment.
  4. Investing

    Return on investment versus internal rate of return

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  5. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  6. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
  7. Personal Finance

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
  8. Investing

    Wal-Mart's Cloud Initiative May Help Drive Profit

    Data Café could help Wal-Mart reduce "lost" sales.
  9. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
RELATED TERMS
  1. Profitability Index Rule

    The profitability index rule is a regulation for evaluating whether ...
  2. Pooled Internal Rate Of Return - PIRR

    Pooled internal rate of return is a method of calculating overall ...
  3. Unconventional Cash Flow

    An unconventional cash flow is a series of inward and outward ...
  4. Required Rate Of Return - RRR

    The required rate of return is the minimum return an investor ...
  5. Capital Budgeting

    Capital budgeting is the process in which a business determines ...
  6. Capital Project

    A capital project is a long-term investment project designed ...
Trading Center