Internal Rate of Return

An internal rate of return (IRR) communicates an average annual profit which can be calculated based on income and expenses over specific periods of time (cash flow). The process used to find an internal rate of return is known as the internal rate of return method or IRR method.

The procedure used by the IRR method takes the timing of transactions into account in addition to the size of cash inflows and outflows.

In many cases, it is not possible to calculate an internal rate of return using a closed formula. In these cases, a numerical root procedure is used.

The IRR method cannot be applied to all cash flows. In some cases the calculation may produce no result, or it may produce multiple internal rates of return. But for certain use cases, such as loans which are repaid via a series of installments, it is always possible to calculate the internal rate of return of the cash flow.

In the case of personal loans, internal rate of return is identical to the effective annual interest rate. A loan, from the lenders perspective, is an investment based on a number of factors such as principal repayments, payment of interest and the loan term. The internal rate of return communicates the lender’s profit on the loan in question.

More on this topic:
Effective annual interest rate explained
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