Internal Rate of Return (IRR) Calculator
Calculated IRR
Understanding How IRR is Calculated
The Internal Rate of Return (IRR) is a critical financial metric used in capital budgeting to estimate the profitability of potential investments. Effectively, IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
When you use an IRR calculated tool, you are looking for the annualized effective compounded return rate. If the IRR of a project exceeds a company's required rate of return (often called the hurdle rate), the project is generally considered a good investment.
The Mathematical Formula
The IRR is the value of 'r' that satisfies the following equation:
0 = CF₀ + CF₁/(1+r)¹ + CF₂/(1+r)² + … + CFₙ/(1+r)ⁿ
- CF₀: Initial investment (Negative cash flow)
- CF₁, CF₂…: Cash inflows for each period
- r: Internal Rate of Return
- n: Number of periods
Example Calculation
Imagine you invest $10,000 into a small business project. Over the next three years, the project returns $4,000, $5,000, and $6,000 respectively. To find the IRR, we solve for 'r' where:
-10,000 + 4,000/(1+r)¹ + 5,000/(1+r)² + 6,000/(1+r)³ = 0
In this specific case, the IRR calculated would be approximately 21.6%. This high percentage suggests a very healthy return on the initial $10,000 outlay.
Why Investors Use IRR
IRR is preferred by many financial analysts because it provides a single percentage figure that can be compared across different projects of varying sizes. However, it is important to remember that IRR assumes all intermediate cash flows are reinvested at the same rate as the IRR itself, which may not always be realistic.