Internal rate of return (IRR) is a financial metric used to predict the profitability of a project or asset. In effect, IRR is a measure of the expected annual return on investment. IRR is calculated by assuming the net present value (NPV) of cash flows is equal to zero and conducting a future cash flow analysis.
Case Study
As a simple example, consider a hypothetical project that requires an initial investment of $50,000. This project will return no cash flow for the first two years but will sell for $65,000 in the third year. The IRR for the project would be 9.12%. If the project produced a cash flow of $1,000 in the first year and $2,000 in the second before selling in the third, the IRR would be 11.03%.
Calculating IRR requires a somewhat complex equation. This equation is as follows:
NPV=t∑(Ct/(1+IRR)^t)-C0
Where:
NPV=0
Ct=cash flow during period t
C0=total cost of investment
t=the number of time periods over which the rate is being calculated
IRR=internal rate of return
For retail investors, the simplest method for calculating IRR is to use a free online return calculator. With an IRR calculator, you can simply plug in the current value, expected future value, and cash flows to get the rate.
You can also use Excel to quickly calculate the internal rate of return on a project or asset. To start, put the cost of the investment into the first cell of a spreadsheet. Next, plug the expected cash flows for each period into the cells underneath. Once you’re finished, you can use the ‘=IRR’ function command to calculate the rate of return. The beginning and ending cells used earlier are set as an argument. For instance, ‘=IRR(A1:A6)’ calculates IRR for the cells from A1 to A6.
A project or asset’s internal rate of return is useful for determining its potential as an investment. In business, companies frequently use IRR to decide whether or not to pursue a project. A positive IRR indicates that the project will be profitable for the company, while a negative IRR suggests that cash flows will be too volatile or unpredictable to reliably generate profits. When choosing between two or more potential projects, companies can also use the IRR metric to decide which will be most profitable.
When it comes to investing, the metric is used to evaluate how well an asset will perform over time. You might, for example, calculate the IRR for a real estate investment based on its rental cash flow and future projected sale price. Knowing the internal rate of return can help you decide whether the property is worth buying or if your money would generate higher returns elsewhere.
Despite its usefulness, there are certain limitations that come with using IRR. The most important is that IRR tells you nothing about the size of the project, only the returns it will generate. A very large project with a lower internal rate of return could actually be a better overall investment than a small one with a very high IRR.
There is no objective standard for what makes a good IRR. Generally, the calculated rate of return is weighed against a minimum acceptable rate defined by a company or individual. If you decided that the minimum acceptable return on a property acquisition was 10%, for example, an IRR of 8% wouldn’t meet your criteria. An IRR of 12%, on the other hand, would exceed your minimum and therefore be a good rate of return.
The bottom line
Internal rate of return is a measure of the profitability of a project or asset. The rate is calculated by setting the net present value of current cash flows to zero. Internal rate of return metrics allow businesses and investors to choose the best places to put their money in order to maximize profit.
