Internal Rate of Return (IRR) is a financial calculation determining the rate of return at which the net present value (NPV) of a project's cash flows sums to zero. Businesses use IRR to evaluate projects. Projects with higher IRR provide greater financial benefit to the organisation. IRR is not a perfect project evaluation tool. IRR does not consider size or time frame of different projects. Managers should use IRR in conjunction with other evaluation tools and sound judgment.
- Skill level:
- Moderately Challenging
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Things you need
- Project financials
- Spreadsheet or financial calculator
Determine the project's cash flows from the project financials. Calculate net cash flows for each period. Periods are generally years. Shorter periods, such as months or quarters, can be used. The calculations for shorter periods, however, become far more cumbersome. Consider cash outflows to be negative numbers, cash inflows to be positive numbers.
Write out the project's periodic cash flows into the IRR formula. The IRR formula is the sum from 0 to n of each cash flow divided by 1 plus the IRR raised to the nth power equals zero, where n is the number of periods. Cash flow at time zero is the initial cash outlay for the project. Each subsequent cash flow is revenues minus expenses for the period.
Use a spreadsheet or financial calculator to perform the IRR formula calculation. Electronic spreadsheets, such as Microsoft Excel, generally have an IRR function. The calculations can also be done by trial and error. Start with a guess for the IRR--10 per cent or .10 is usually a good place to start. If your result is a positive number, lower the guess for the second try. Continue calculating using guesses of IRR, bracketing to get closer and closer until the desired degree of accuracy is reached.
Tips and warnings
- IRR can also be calculated using the net present value (NPV) formula or NPV function of a spreadsheet or financial calculator. The rate of return that results in a NPV of zero is the IRR.
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