A:

Both of these measurements are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

To do this, the firm estimates the future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment.

Let's illustrate with an example: suppose JKL Media Company wants to buy a small publishing company. JKL determines that the future cash flows generated by the publisher, when discounted at a 12% annual rate, yields a present value of \$23.5 million. If the publishing company's owner is willing to sell for \$20 million, then the NPV of the project would be \$3.5 million (\$23.5 - \$20 = \$3.5). The \$3.5 million dollar NPV represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition.

So, JKL Media's project has a positive NPV, but from a business perspective, the firm should also know what rate of return will be generated by this investment. To do this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR).

For this example, the project's IRR could, depending on the timing and proportions of cash flow distributions, be equal to 17.15%. Thus, JKL Media, given its projected cash flows, has a project with a 17.15% return. If there were a project that JKL could undertake with a higher IRR, it would probably pursue the higher-yielding project instead. Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's return and to compare it with other possible investments.

RELATED FAQS
1. ### Which is a better measure for capital budgeting, IRR or NPV?

All other things being equal, using IRR and NPV measurements to evaluate projects often results in the same findings. However, ... 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. ### 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 >>
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. ### 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 >>
6. ### What is the relationship between the hurdle rate (MARR) and the Internal Rate of ...

Find out how companies and managers use hurdle rate, or MARR, and internal rate of return, or IRR, to evaluate projects and ... Read Answer >>
Related Articles
1. Investing

### An Introduction To Capital Budgeting

We look at three widely used valuation methods and figure out how companies justify spending.

### Calculating the Internal Rate of Return Using Excel

The internal rate of return on investments is explained and illustrated in different investment scenarios.
3. Investing

### How to Calculate Required Rate of Return

Investors use the required rate of return to decide where to put their money, and corporations use it to decide if they should pursue a new project.

### Modified Internal Rate of Return (MIRR)

Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
5. Investing

### Analyze Cash Flow The Easy Way

Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.

### How to Compare Permanent Life Insurance Policies

How you can use the internal rate of return to compare and purchase a permanent life insurance policy.
7. Tech

### Cash Flow Is King: How to Keep it Running

Why is cash flow so important, and what steps can a business take to improve it?
RELATED TERMS
1. ### Internal Rate Of Return - IRR

A metric used in capital budgeting measuring the profitability ...
2. ### IRR

The currency abbreviation or currency symbol for the Iranian ...
3. ### IRR Rule

A measure for evaluating whether to proceed with a project or ...
4. ### The Net Internal Rate Of Return - Net IRR

A measure of a portfolio or fund's performance that is equal ...
5. ### Net Present Value Rule

A rule stating that an investment should be accepted if its net ...
6. ### Initial Cash Flow

The amount of money paid out or received at the start of a project ...
Hot Definitions
1. ### Time In Force

Time in force is a special instruction used when placing a trade to indicate how long an order will remain active before ...
2. ### Retirement Planning

Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
3. ### Drawdown

The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
4. ### Inverse Transaction

A transaction that can cancel out a forward contract that has the same value date.
5. ### Redemption

The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
6. ### Solvency

The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...