Understanding IRR
The IRR is the discount rate at which the NPV is 0. Where there are several projects, the IRR is used to rank them so that the higher the IRR, the more desirable the project. With all other things being equal, the project with the highest IRR is recommended.
The following are the criteria for accepting the project:
- Where the IRR is greater than the discount rate, accept the project.
- Where the IRR is less than the discount rate, reject the project.
The IRR can be obtained by substituting various amounts for the discount factor while observing the NPV until you arrive at a discount factor that results in an NPV of 0.
Alternatively, we could use the Goal Seek function under What-If Analysis in the Data Tools section of the Data ribbon in Excel. We shall illustrate this in the solution to our case study.
