Internal Rate of Return (IRR) is the most sophisticated of the above metrics and often is used to analyze large, multi-year investments. IRR equals the percentage rate by which you have to discount the net benefits for your time period until the point that they equal the initial costs. IRR is related closely to net present value. The discount rate you would need to apply to your benefits to obtain a net present value of zero is the rate of return calculated by IRR.
The pluses of Internal Rate of Return include:
- It takes into account the time value of money
- It is particularly good for measuring uneven annualized returns
Minuses? There are a couple:
- It is complex to calculate
- It offers no magnitude for a project
The expression for IRR (in this case, a three-year IRR) is:
initial costs = net benefit year 1 / (1+IRR) + net benefit year 2 / (1+IRR)^2 + net benefit year 3 / (1+IRR)^3
IRR is often calculated through a trial-and-error process or data table since solving the above equation is very time-consuming.