Internal Rate of Return (IRR) Calculator
Calculate the profitability of your potential investment project.
How Internal Rate of Return is Calculated
The Internal Rate of Return (IRR) is a critical financial metric used in capital budgeting to estimate the profitability of potential investments. It is formally defined as the discount rate that makes the Net Present Value (NPV) of all cash flows (both positive and negative) from a particular project equal to zero.
Mathematically, the Internal Rate of Return is calculated by solving the following equation:
Where:
- CF₀: The initial investment (usually a negative number).
- CF₁, CF₂, … CFₙ: The cash flows for each period.
- r: The Internal Rate of Return we are solving for.
- n: The total number of periods.
Real-World Example
Suppose a business is considering a new machinery purchase that costs $50,000. This machine is expected to generate $15,000 in additional revenue every year for the next 5 years. To find the IRR, we need to find the rate 'r' where the cost equals the sum of the discounted future revenues.
In this example, the IRR would be approximately 15.24%. If the company's cost of capital is 10%, this project would be considered a good investment because the IRR (15.24%) is higher than the cost of capital.
Interpreting the Results
Generally, when comparing multiple investment opportunities, the project with the highest IRR is often considered the most desirable. However, it is important to use IRR alongside other metrics like NPV (Net Present Value) or ROI (Return on Investment) because IRR assumes that all interim cash flows are reinvested at the same internal rate, which may not always be realistic.