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Internal Rate of Return

The document discusses the internal rate of return (IRR), which is a metric used to estimate the profitability of potential investments. IRR is calculated by finding the discount rate that results in a net present value of zero for an investment. A higher IRR generally indicates a more desirable investment. The document provides the formula for calculating IRR, as well as examples of how to calculate IRR manually and using the IRR function in Excel.

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Cris Baggeo
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19 views

Internal Rate of Return

The document discusses the internal rate of return (IRR), which is a metric used to estimate the profitability of potential investments. IRR is calculated by finding the discount rate that results in a net present value of zero for an investment. A higher IRR generally indicates a more desirable investment. The document provides the formula for calculating IRR, as well as examples of how to calculate IRR manually and using the IRR function in Excel.

Uploaded by

Cris Baggeo
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Internal Rate of Return (IRR): Formula and

Examples
By
JASON FERNANDO

Full Bio

Jason Fernando is a professional investor and writer who enjoys tackling and
communicating complex business and financial problems.
Learn about our editorial policies

Updated March 14, 2024

Reviewed by
KHADIJA KHARTIT
Fact checked by
RYAN EICHLER
0 of 1 minute, 30 secondsVolume 0%

What Is IRR?
IRR, or internal rate of return, is a metric used in financial analysis to estimate
the profitability of potential investments. IRR is a discount rate that makes
the net present value (NPV) of all cash flows equal to zero in a discounted
cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that
IRR is not the actual dollar value of the project. It is the annual return that
makes the NPV equal to zero.

Generally speaking, the higher an internal rate of return, the more desirable
an investment is to undertake. IRR is uniform for investments of varying types
and, as such, can be used to rank multiple prospective investments or
projects on a relatively even basis. In general, when comparing investment
options with other similar characteristics, the investment with the highest IRR
probably would be considered the best.

KEY TAKEAWAYS

 The internal rate of return (IRR) is the annual rate of growth that an
investment is expected to generate.
 IRR is calculated using the same concept as net present value (NPV),
except it sets the NPV equal to zero.
 The ultimate goal of IRR is to identify the rate of discount, which makes
the present value of the sum of annual nominal cash inflows equal to
the initial net cash outlay for the investment.
 IRR is ideal for analyzing capital budgeting projects to understand and
compare potential rates of annual return over time.
 In addition to being used by companies to determine which capital
projects to use, IRR can help investors determine the investment return
of various assets.
Investopedia / Julie Bang

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The Formula for IRR


The formula used to determine IRR is as follows:

How to Calculate the IRR

The manual calculation of the IRR metric involves the following steps:

1. Using the formula, one would set NPV equal to zero and solve for the
discount rate, which is the IRR.
2. Note that the initial investment is always negative because it represents
an outflow.
3. Each subsequent cash flow could be positive or negative, depending on
the estimates of what the project delivers or requires as a capital
injection in the future.

Because of the nature of the formula, IRR cannot be easily calculated


analytically and instead must be calculated iteratively through trial and error
or by using software programmed to calculate IRR (e.g., using Excel).1

How to Calculate IRR in Excel


Using the IRR function in Excel makes calculating the IRR easy. Excel does
all the necessary work for you, arriving at the discount rate you are seeking to
find.

1. Enter Cash Flows: In an Excel spreadsheet, list all the cash flows
associated with the investment or project. These cash flows can be
both positive (inflows) and negative (outflows).
2. Arrange Cash Flows: Organize the cash flows in chronological order,
with the initial investment (usually a negative value) at the beginning
and subsequent cash flows listed in the order they occur.
3. Use IRR Function: In a cell where you want the IRR value to appear,
use the IRR function. The syntax for the IRR function is: =IRR(values)

 The "values" are the range of cells containing the cash flows. Make
sure to select all cash flows including the initial investment.
 Example: Let's say your cash flows are in cells A1 through A5, where
A1 represents the initial investment and A2 through A5 represent
subsequent cash flows. You would input the following formula in a cell
where you want the IRR displayed: =IRR(A1:A5)

Here is a simple example of an IRR analysis with cash flows that are known
and annually periodic (one year apart). Assume a company is assessing the
profitability of Project X. Project X requires $250,000 in funding and is
expected to generate $100,000 in after-tax cash flows in the first year and
grow by $50,000 for each of the next four years.

In this case, the IRR is 56.72%, which is quite high.

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