Internal Rate of Return Calculation and Tips/ Formulas:
The IRR is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. Download IRR Calculation and Learning Material PDF from here..
What is Internal Rate of Return-IRR
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
Formula for Calculating Internal Rate of Return- IRR
The following is the formula for calculating NPV:
Ct = net cash inflow during the period t
Co= total initial investment costs
r = discount rate, and
t = number of time periods
Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects a firm is considering on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
Uses of IRR:
i. Profitability of an Investment:
Organizations use IRR in capital budgeting to compare the profitability of capital projects in terms of the rate of return. For example, an organization will compare an investment in a new plant versus an extension of an existing plant based on the IRR of each project. To maximize returns, the higher a project’s IRR, the more desirable it is to undertake the project. If all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.
ii. Maximizing Net Present Value:
The internal rate of return is an indicator of the profitability, efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the net value or magnitude added by making an investment.
iii. Fixed Income:
If an investment may be given by the sequence of cash flows
then the IRR of a given project would be:
In this case, the answer is 5.96% (in the calculation, that is, r = .0596).
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