Question

What is the decision rule for IRR?

Short answer

Answer

According to the IRR rule, a project or investment can be pursued if the IRR is higher than the required rate of return, which is often the cost of capital. The best course of action might be to reject a project or investment if, on the other hand, the IRR is less than the cost of capital.

Step-by-step solution

Definition

In financial analysis, the internal rate of return (IRR) is a statistic used to calculate the profitability of possible investments. IRR is a discount rate that, in a discounted cash flow analysis, reduces all cash flows' net present values (NPV) to zero.

Calculation

IRR is calculated by,

IRR = [(Cash flows) / (1+r)^i ] – Initial investment

Where;

Cash flows = cash flows in the time period

r = Discount rate

i = Time period