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The Internal Rate of Return (IRR) is a Money Weighted Return metric, which is expressed as a percentage. It enables investors to judge financial performance based on cash flows such as money deposited, varying investment returns and money withdrawn over a defined time interval period.
The Internal Rate of Return (IRR) on an investment, is expressed as an interest rate received from a series of cash flows for a defined period. The Annual Rate of Return (ARR) is based on a yearly interval time period, whereas the Monthly Rate of Return (MRR) for example is based on monthly interval time period.
Internal Rate of Return (IRR) can be defined as the rate of return that can be earned on invested capital over time i.e. the yield on an investment. For example, if you invested money in a Savings Account which guaranteed a fixed yearly interest payment of 5%, then the Annual Rate of Return for that Saving Account would be 5%.
Internal Rate of Return (IRR) calculations are commonly used by investors to determine the rate of return for investments that generate varying returns over time. It enables investors to make 'apples for apples' comparisons of two completely different investments or investment performance profiles, by establishing the Internal Rate of Return for each investment. The investment opportunity with the highest Internal Rate of Return, assuming execution risk is equal, is likely to generate the best return on capital invested.
Stock market investors and funds use Internal Rate of Return (IRR) calculations to compare their performance to indices or other investors / fund, as it overcomes the limitations associated with using Time Weighted Return metrics, such as the Unit Valuation System. Although the Internal Rate of Return (IRR) provides an excellent mechanism for determining your actual rate of return and comparing performance, it is not suitable for managing day-to-day investment fund valuations, managing the inclusion or exclusion of expenses and apportioning ownership based on the buying and selling of units; the Unit Valuation System is best suited to this task.
Mathematically the Internal Rate of Return (IRR) is defined as any discount rate that results in a net present value of zero for a series of cash flows. Internal Rate of Return (IRR) is based on the same mathematical principles for determining the Net Present Value (NPV). NPV shows the value of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return. IRR on the other hand, calculates the break-even rate of return. Most investors tend to use IRR calculations rather than NPV calculations, as IRR is represented as a percentage and therefore easier to understand.
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