IRR Guide for Analysts

The internal rate of return (IRR) is the discount rate that drives the net present value (NPV) of a project to zero. In other words, the total annual return expected to be achieved on a project or investment. In the example below, his IRR for an initial investment of $50 is 22%. This corresponds to an average annual growth rate of 22%.

Internal rate of return (IRR) chart.

When calculating IRR, given the expected cash flows of a project or investment, the NPV is zero. In other words, the initial cash investment in the initial period is the present value of the future cash flows from that investment. (Costs paid = present value of future cash flows, hence NPV = 0).

Once the internal rate of return is determined, it is typically compared to the firm's hurdle rate or cost of capital. If the IRR equals or exceeds the cost of capital, the company accepts the project as a good investment. (With the proviso, of course, that this is the sole basis for the decision. In practice, many other quantitative and qualitative factors influence investment decisions. ) if the IRR is lower than the hurdle rate, it will be rejected.

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What is the IRR formula?

The formula for IRR is:

Internal rate of return (IRR) formula.

The internal rate of return can be calculated in three ways:

Using the IRR or XIRR functions in Excel or other spreadsheet programs (see examples below)

Using the financial calculator

Use an iterative process in which the analyst tries different discount rates until the NPV is zero (you can use Goal Seek in Excel for this).

practical example

Here is an example of calculating the internal rate of return.

A company decides whether to purchase new equipment that costs $500,000. Management expects the new asset's life, he estimates, to be four years and will generate an additional $160,000 in annual profits. In year 5, the company plans to sell the equipment for a salvage value of $50,000.

On the other hand, another similar investment option gives a 10% return. That's higher than the company's current hurdle rate of 8%. Its purpose is to enable the company to make optimal use of its liquidity.

to make the decision

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