The Internal Rate of Return (IRR) is a financial metric used to assess the profitability of an investment or project. It represents the average annual return an investment is expected to generate over its lifespan.
To understand IRR, let’s look at a simple example:
Imagine you’re considering investing in a project that will cost 100,000 SEK to start. Over the project’s lifespan, you expect to receive cash flows as follows:
– Year 1: 30,000 SEK
– Year 2: 40,000 SEK
– Year 3: 50,000 SEK
To calculate the IRR, you solve the equation where the net present value of the future cash flows is zero. In other words, the IRR is the interest rate that makes the present value of the future cash flows match the initial investment.
In this case, the IRR might be, for example, 15%. This means that if you invest 100,000 SEK, you will receive back 145,000 SEK over the project’s lifespan, resulting in an average annual return of 15%.
IRR is used to compare different investment opportunities and determine which project offers the best return relative to its risk and initial investment. The higher the IRR, the more profitable the investment.
It’s important to note that IRR doesn’t take into account other factors like risk and liquidity, so it’s best used in conjunction with other analysis methods to make well-informed investment decisions.
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