Internal rate of return

Internal rates of return (IRR) are also considered during product selection, because the process allows the calculation of the rate of return on the project without any external factors to consider, such as inflation or the cost of capital. IRR also considers the time value of money and is really designed to look at returns on investments and what they are worth today versus what they might be worth in the future.

A return on investment that occurs tomorrow is worth more than the same return two years from now. The longer the return on investment takes, the lower the internal rate of return becomes. In general, organizations can use IRR as a litmus test for profitability, and using NPV, the organization can attempt to prove net value if an investment is made.

An easy way to think about the internal rate of return is to consider walking into a bank and asking about opening up a savings account. The financial adviser at bank A states that if you keep your money with them, you will get a 1.0% return on your investments. The financial adviser at bank B states they will give you a 3.5% return on your investment. Which one would you choose? I'm betting you would choose the latter. Organizations are no different.

It is the job of the business analysts to crunch the numbers and look to the future to determine the best decisions to make financially. Those considerations can help organizations select the best projects. There are also big, scary formulas involved with all of these, but the good news is you don't need to know them for the exam!

A good way to keep these all straight is to always choose the highest number except in the payback period where you would want to choose the lowest. If the question has all three variables, review each project and determine which would be most profitable for the organization. Typically, in the exam situation, the NPV is the key indicator of a profitable project.