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Internal Rate of Return

Another factor in conventional ROI analysis is the internal rate of return (IRR). This is the interest rate, or cost of capital, at which the NPV for the project becomes zero.

The usefulness of IRR is a matter of some debate, so it is not a term we deal with extensively in this book. However, it is an interesting concept, for the following reason.

NPV alone does not give us enough information to answer the question “is this project worth doing?” If a particular development project has an NPV greater than zero, undertaking the project is certainly a better investment than doing nothing at all. However, it doesn't tell us anything about whether this is the best thing to be doing in comparison with other possible money-generating activities.

For example, if the application's NPV is positive only when interest rates are 6% per year or less, but we know we can get an 8% return from low-risk bank deposits, the application development may not be worth doing. We would make more money just by depositing the money in a bank. The IRR, or the interest rate at which the NPV is zero, is thus an interesting metric in conventional ROI analysis and provides us with a useful yardstick for evaluating a positive NPV.

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