Internal Rate of Return (IRR)

The internal rate of return (IRR) is what you get back (increase or decrease) for what you put in, in this case internally over a defined period of time. You may not have heard this definition from an economist or accountant, but in its true form it is accurate.

The term internal rate of return is most commonly used in business, understanding that return considering cash flows based on an “internal” investment of “capital” (money, resources, time, and so on). This is a very common method of analyzing a major investment (such as a capital project, reallocating resources, or change of a process), allowing you to consider the multiple variables. Most commonly, you find the investment rate (interest rate) that is equivalent to the dollar value return you expect from the investment. Once you have calculated the “rate,” you can compare the rates you could earn from other investments of the same resources. It allows you to find the interest rate that is equivalent to the dollar returns you expect from your project, taking into consideration the time value of money.

There are various definitions for internal rate of return used, but the way this term is used in today’s business world takes into account various characteristics. When someone and its strategic capacity. It is important not to be paralyzed by the need for additional information. [Page 303]starts out, “The internal rate of return is…,”begin to think about the variables that follow and questions you would ask in order to understand them.

A fairly common definition might read thus: The realized return for an internal investment taking into consideration the time value of money, over a defined period of time (usually annually).

Here is a simple example: If you invested $100 and earned 10% on an annual basis, your rate of return would be $10 or 10%, if there were no inflation or deflation associated with the investment.

If you invested $10 and earned 10% on an annual basis but inflation was 3%, then your rate of return annually would be $7, or 7% (10% – 3% = 7%).

Let’s suppose the investment deals with medical equipment. If the “internal rate of return” (percentage) is less than the cost of borrowing (interest rate or percentage of cost of capital) used to fund your project, the project will clearly not be a good investment in monetary terms. A common practice in health care evaluations is that a purchase or investment will have a projected IRR that is at multiple percentage points higher than the cost of the acquisition, to make up for its risk and other factors associated with the project. There may be nonmonetary factors included in the evaluations such as lost opportunity cost (what will happen if we do not invest?), quality of care issues, and additional resource retention or recruitment.

Here is a simple example of how this IRR might work in health care:

Let’s propose you are about to purchase a large piece of medical equipment, and the total cost to own this piece of equipment is $1.5 million. You expected to increase your revenues (cash flow) over a five-year period by $700,000, $600,000, $300,000, $200,000, and $100,000 a year respectively, or $1.9 million (five years of cash flow) in total, because of the investment. With all factors considered (depreciation, cost of operation, taxes, and so on), let’s estimate the desired internal rate of return for the project would be approximately 12%.

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