The calculation steps of the internal rate of return

The internal rate of return (IRR) is one of the most used financial indicators to evaluate the profitability of an investment. In practice, this is the interest rate that makes the net present value of a project’s cash flows equal to zero. In other words: it is the return offered by an investment, expressed as a percentage. Now, how to calculate the internal rate of return? 

We’ll tell you something: performing the calculation is not an easy task, but in this post, we will help you with some tips and practical examples. In addition, we explain what drawbacks the IRR has and how the result is interpreted. Keep reading! 

What is needed to calculate the internal rate of return? 

Before starting with the calculation steps, it is important that you know that the IRR is very useful to know what is the minimum return that you should demand for an investment to be profitable. Additionally, if you are hesitating whether or not to accept a project, the IRR can help you make decisions based on whether it is greater or less than the opportunity cost or the discount rate.  

Regarding the calculation, we have good news for you: there are computer tools that facilitate the calculation of the IRR, such as Excel, financial calculators or spreadsheet programs. These tools usually have a specific function to calculate the IRR, which usually requires the following data: 

• The initial value of the investment, which is entered as a negative number, since it represents a disbursement or outflow of money. 
• The expected cash flows from the investment, which are entered as positive numbers, since they represent income or inflows of money. 
• The number of periods that the investment lasts, which can be annual, monthly or quarterly. 

In the next section, we better explain the concept of the IRR and its calculation with an example. 

Example of calculating the internal rate of return 

Suppose that we want to invest in a company that requires an initial investment of 50,000 euros and that is going to generate net profits of 15,000, 20,000, 25,000 and 30,000 euros in the following four years. What is the IRR of this investment? We are going to use the Excel IRR function to find out: 

1. In cell A1 we enter the initial value of the investment. Remember that it must be negative: -50,000 euros. 
2. In cell A2, A3, A4 and A5 we enter the net benefits. 
3. In cell A6 the formula =IRR(A1:A5) is then entered. 

The result that Excel will give us from this formula will be 0.2874. This is taken as a percentage, that is, the IRR of this investment would be 28.74%.  

Below, we explain in more detail how to determine whether the investment is profitable or not.  

Interpretation of the result of the internal rate of return 

Once the IRR of a project has been calculated, the result must be interpreted to know whether to accept or reject the project. To do this, we must compare the IRR with the opportunity cost or the discount rate, which is the minimum return expected to be obtained from an investment. 

Generally: 

• If the IRR is greater than the opportunity cost, the investment is profitable and the project should be accepted. 
• If the IRR is less than the opportunity cost, the investment is not profitable and the project should be rejected. 
• If the IRR is equal to the opportunity cost, the investment is indifferent and the project can be accepted or rejected. 

Continuing with the previous example, if the opportunity cost of this investment is 10%, then the IRR (28.74%) and, therefore, it is profitable and the project should be accepted. 

Disadvantages of the internal rate of return 

Finally, we tell you that although the IRR is a widely used indicator, it has some drawbacks that you should take into account:  

• It can give erroneous or misleading results when the cash flows of a project change sign more than once, that is, when there are alternating inflows and outflows of money.  
• If projects with different durations or different investment sizes are compared, the net present value results may be inconsistent or contradictory.  
• The IRR assumes that the cash flows generated by a project are reinvested at the same interest rate as the IRR, which may not be realistic or optimal.  

Did you find this post on how to calculate the internal rate of return interesting? Would you like to know how to take your project or company one step further? Subscribe to Educa.Pro and discover all the news! 

Also you can read about the following topics:

• Pricing strategies: How to define the value of your product
• 5 lean manufacturing tools you should know