Internal Rate of Return
The internal rate of return (IRR) is that discount rate that equates the present value of the cash flows with the initial investment cost. Suppose Rt is the net cash flow in year t, C is the initial cost of the project, and n as the life of the project. The IRR can be calculated by solving the following equation for k*, the internal rate of return.
∑nt=1 [Rt/(1+ k*)s] - C0
The decision rule is that if k* is greater than the cost of capital, or the risk adjusted discount rate, the investment should be made. That is, profits, and therefore, the value of the firm, will be increased by making this investment.
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