Rate of return analysis is the last of the three methods that analyze measures of investment worth.  The two that we have already discussed are the present worth and annual cash flow analyses.  We also discussed future worth analysis, but it was classified under present worth analysis since the two methods are similar.  Rate of return analysis, the analysis technique that will be discussed now, is based on the measure of yield from a project.

The text provides three definitions of rate of return.  Definitions 1 and 3 are essentially the same and they help to describe why the term internal is used with rate of return to denote the return from a project.    Definition 2 is based on the mathematical solution for the interest rate that makes the net present worth (NPW) equal to zero.  This break-even interest rate is denoted by i*.

The term internal rate of return (IRR) signifies the internal nature of the rate of return from an investment.  In other words, IRR is the return one obtains internally from the investment.  As long as the project balance during each year of the project life is negative, until the last year when it is zero, the return from the investment in the project is internal.  As we will see later, if the project balance is positive in any one year of the project, the need for investing the positive balance somewhere else, externally, arises.  This need for external investment complicates the computation of IRR as we shall see later.