Internal Rate of Return (IRR)

The IRR method is more complex but has the advantage of comparing projects of different sizes. The IRR is the discount rate that equates the present value of the expected future cash flows to the project's initial cost (e.g., the purchase of a new instrument). The image on the right shows the equation and an example calculation.

The main advantage of IRR is that it expresses the return on investment in percent, fostering easy comparison of projects of different sizes. For example, institution management might use it to decide whether to invest in a new instrument for the laboratory or a new X-ray machine with their limited capital equipment budget for the year. If one has a significantly higher IRR, that will likely influence their decision if all other factors are equal. Fortunately, some computer-generated calculators can be found online and used to determine IRR. An example site is https://www.thecalculatorsite.com/finance/calculators/irr-calculator.php.

For several reasons, NPV may be the best financial indicator for a capital equipment project. One reason is that the internal rate of return (IRR) calculates the rate of return the project offers irrespective of the required rate of return and other things. Another disadvantage is that IRR does not understand economies of scale and ignores the dollar value of the project. It cannot differentiate between projects with the same IRR but a vast difference between dollar returns. On the other hand, NPV talks in absolute terms, so this point is not missed.