Introduction
The internal rate of return (IRR) is the discount rate that sets the present value of a project or investments future net cash flows equal to its initial cost or net present value (NPV). It is an indicator of the returns generated by a project or an investment and is used to compare competing investments and determine a course of action.
IRR is a metric that takes into account all the costs and liabilities and presents a figure that can be used to measure the potential of a project and calculate returns. It is a powerful tool for comparing strategies and assessing the viability of a project based on projected returns, risk and level of investment required.
Calculating Internal Rate of Return (IRR)
There are several methods used to calculate IRR. The most common approaches are the trial and error method and the Excel spreadsheet method. In the trial and error method, the NPV is calculated for different discount rates and compared to the initial cost. The discount rate at which the NPV equals the initial cost is the IRR.
In the Excel Spreadsheet method, the formula “=IRR (A1:A n)” is used to calculate the internal rate of return, where A1:A n represents the cash flows.
An alternative method which avoids unnecessary iterations is the net present value (NPV) method. This approach uses the fact that, by definition, the present value of all expected future cash flows at the IRR, should be equal to the initial investment. Therefore, different values of the IRR may be used to obtain the appropriate reflection of the future cash flows for a corresponding set of initial conditions (discount rate, cash flows) until the NPV of the cash flows equals the initial investment.
The following formula may also be used to calculate
