How to Calculate IRR With a Growing Cash Flow
IRR (Internal Rate of Return) has long been an important measurement in business circles, but it is a bit challenging if you use pencil, paper and a calculator. The calculations become somewhat easier if cash flows are growing (you don't need to use negative numbers), but the challenge remains. IRR is an indicator of investment quality, efficiency and/or yield. To eliminate most of the challenge, use Microsoft Excel and its IRR formula.
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Things You'll Need
- Calculator
- Microsoft Excel
- Online IRR calculator
- Investment and cash flow amounts over specified time periods
Instructions
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Calculate IRR with Growing Cash Flow
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Identify or predict cash flows for the coming three to five years. Or calculate IRR for prior years to learn how efficient your company operations were. This data could serve as your benchmark to measure projected future IRR. If you choose to calculate IRR for one year, use monthly or quarterly cash flow amounts to plug into your formula.
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Set up the IRR formula. NPV (net present value) equals C(0) + C(1)/(1+r) + C(2)/(1+r)2 + ... + C(n)/(1+r)n. C equals cash flow. C(0) would equal your investment. C(1), C(2), C(3), etc. equals your cash flows in subsequent years or other time periods. The "r" equals the rate. Setting the NPV to equal 0 allows you to solve for r. This equals your IRR.
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Use a trial-and-error approach when calculating a manual formula. This is the primary challenge to solving the equation manually. Since you want the NPV to equal 0, you must plug in some numbers to be able to solve for "r." This is why it is much easier, faster and more accurate to use an Excel spreadsheet IRR formula or an online IRR calculator. However, as a business manager, you should still understand the basic components of the manual formula.
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Test your answer using the IRR formula built into Excel spreadsheet functions or inputting your cash flow data into an online IRR calculator. These tools immediately give you the answer you laboriously calculated using the manual IRR formula. If there is a large discrepancy, recheck your manual calculations to help you learn the essence and meaning of the underlying components of the IRR formula.
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Analyze your answer. Growing cash flows are positive indicators of efficient business operations and the quality of your investment in the company. You can compare your IRR with the returns of other similar companies to evaluate the effectiveness of your business. The higher the IRR the better, but rates of return can vary widely. For example, if you calculate an IRR of 14 percent, you will be pleased -- unless you learn that competing companies enjoy an average of a 17 percent IRR.
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Tips & Warnings
Practice solving the IRR formula with small numbers and simple examples to become comfortable with the equation. Use easy numbers. You can always add zeros.
Learn to use Excel or online IRR calculators after you understand the formula.
Do not depend on results if you're comparing vastly different companies or investments. Your results will have little meaning as comparison tools.
References
Resources
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