Internal rate of return is commonly known as IRR by those in the
financial industry. To understand internal rate of return, you must
first know what is NPV or net present value. IRR is discounted rate
of return derived based on the condition that net present value for
an investment is 0. IRR is then compared to the company's discounted
rate of return. If IRR is higher than the company's / project's discounted
rate of returns, then the investment is deemed to be worthwhile for the company or investor.
The discounted rate of return for the company is determined
by the investors themselves. Discounted rate of return is derived
based on a number of factors. One of them is the consideration of
risk. If the investor is evaluating a more risky investment, he is
likely to have a higher rate of return. This is to compensate the risk
that he is taking on this project. Another factor that could influence
the discounted rate of return is the general market rate of return.
To calculate the internal rate of return manually (without a
financial calculator) is a very laborious process. It will take
you minutes if not hours. However, using Excel, you can do it in
less than a minute. Assuming that the cash flows (from year 0 to
year 5) is in the range "D $ 3: J $ 3", the formula to der the IRR
is "= IRR (D $ 3: J $ 3)" without quotes.
Now that we have learnt how to calculate the internal
rate of return, it is important to know that IRR can only be
used under certain conditions. The best way to determine if the
IRR can be used is to plot the NPV of the investment against
the discount rate of return. If the NPV crosses the X-axis more
than once, ie NPV is zero more than once, than the investment
is considered to have multiple internal rate of return and should
be used with caution.
It is very safe to use IRR only when the cash inflow or outflow only
changes once. This means that you can have a series of flow
before the inflow comes in. Once the inflow kicks in, outflow can not
be present again. Alternately, you could have a series of inflow
first followed by a series of flow, but inflow of funds can not
appear again. If there are multiple IRR, then it would be difficult
to determine which IRR to use.
If there are changes in the cash flows from negative to
positive and back again to negative, the chances of this
investment having multiple internal rate of return is very