Question

What is the simplest way to explain Internal Rate of Return to non-accountants?

Answer 1

To understand the internal rate of retum (IRR), first of all, the truth underlying net present value (NPV) needs to be considered. In layman's terms, such truth states that the value of a dollar today is much more than a dollar of one year after or in simple terms, a dollar today can make you buy more in comparison to one year after. For example- in case of a business valuation, its projections for future income are taken on a yearly basis and discounted back to their worth in today's dollars. Combining them, we will get the net present value of future income, implying that if such future incomes are earned today, their worth will be equal to such net present value. For calculating the NPV, a discount rate also called as cost of capital is used which means 'how much less will a dollar be worth a year from now'. Now, comes the concept of IRR which means the discount rate at which the NPV becomes zero, i.e. what would be the cost of capital needed to break-even for an investment. In order to evaluate the feasibility of an investment project, IRR needs to be taken into account in the sense that rate of return on such investment project should be higher than the IRR. If it is less than IRR, such project should not be accepted in any case.