Internal rate of return calculations

The Internal Rate of Return (IRR) is the discount rate that generates a zero net present value for a series of future cash flows. This essentially means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or an investment) equal its current market value.

Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project should be avoided if the cost of capital exceeds this rate. Usually a financial calculator has to be used to calculate this IRR, though it can also be mathematically calculated using the following formula:

Equation defining the Internal rate of return

In the above formula, CF is the Cash Flow generated in the specific period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by employing trial and error method.

Internal Rate of Return is the flip side of Net Present Value (NPV), where NPV is the discounted value of a stream of cash flows, generated from an investment. IRR thus computes the break-even rate of return showing the discount rate, below which an investment results in a positive NPV.

A simple decision-making criteria can be stated to accept a project if its Internal Rate of Return exceeds the cost of capital and rejected if this IRR is less than the cost of capital. However, it should be kept in mind that the use of IRR may result in a number of complexities such as a project with multiple IRRs or no IRR. Moreover, IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate.

The Modified Internal Rate of Return (MIRR) is an other financial measure used to determine the attractiveness of an investment.

In IRR calculations, positive cash flows are assumed to be 'paid' instantly to the investor who can use them immediately to reinvest on a new project. But in reality, the positive cash flows are not paid instantly to the investors, but rather kept by the 'project management entity' (ie: venture capital firm, department owning the project...) until the end of the project.

The Modified Internal Rate of Return assumes that the positive cash flows are immediately re-invested until the end of the project. To make these calculations, it is common practice to use the weighted average cost of capital as interest rate on the positive cash flows.

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