How to Determine an Internal Rate of Return
The internal rate of return (IRR) is a tool investors use to determine if an investment is worth it. It determines the efficiency of an investment and, when juxtaposed with the net present value (NPV), or the value of the investment, the figure helps investors make important decisions. The numeric figure of an IRR represents the yield of an investment, compounded annually. The IRR is a discount rate and, when attached to a specific specific project, it should bring the NPV down to zero.
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Instructions
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How to Determine Internal Rate of Return
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Establish your variables. With time (r) and cash flow (CF) as given factors, the internal rate of return is determined by using the formula, 0 = -(initial investment) + CF1/(1 + r)1 + CF2/(1 + r)2 + ... + CFn/(1 + r)IRR. One can either use a present time or a fixed time when determining IRR. In situations where the cash flow is yet to be determined, one would use an estimated figure. The IRR is a "break even" rate and should be greater than the initial investment.
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Know the drawbacks of IRR estimates. Academics have long preferred Net Present Value (NPV) analysis to IRR analysis, but managers prefer working with IRR figures. Technically, the NPV is considered to be more accurate because IRRs do not take into account the reinvestment of cash flow. IRRs are useful in single bank transactions. However, using the IRR formula for a small business investment is tricky since returns may not show up until several years after the initial investment.
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Don't rely on the IRR as the sole decision making factor. One project may have a higher initial investment and a lower IRR, but a higher total net worth in the long run. Moreover, the IRR assumes a reinvestment of cash flow. If this reinvestment does not occur, than the IRR is not representative of the true results.
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Use tools such as Excel and financial calculators. Not only can IRR be represented by a percentage point, one can also construct a graphical representation of the figure using an Excel sheet or financial calculator. The graph could represent a series of investments compared to a series of returns over time. Since monetary value fluctuates over time, it is important to consider the sequence of investments when examining the IRR.
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Analyze what your project's IRR means in the big picture. With the help of an IRR formula, a small business owner can analyze a series of investments over time. In essence, the IRR formula tells them whether their project is a money winner or money loser. In other cases, one may want to make a large investment. By estimating when and how much cash flow will result from the investment, the investor can benefit from IRR analysis.
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