The internal rate of return is one of the most sophisticated tools available for investment appraisal. It is called internal as it doesn’t consider ‘external’ factors such as the following: inflation, cost of capital and risk-free rate. Another name for IRR is discounted cash flow rate of return.
Use the following process to calculate the internal rate of return on a project:
- Use two discount rates. One should give a positive net present value and the other should give a negative net present value.
- Calculate the net present values using each of these discount rates.
- Apply this formula to find the IRR:
(Lower rate + (percentage difference between the rates x NPV using the lower rate))/Difference between the NPVs calculated using the 2 rates
The formula is quite complicated so let’s understand it using an example. But before that, let’s clarify some terms:
- Discount rate: This is the rate that determines the present value of future cash flows. This is different from the cost of capital, which is the minimum rate of return necessary to make an investment worthwhile.
- Net present value (NPV): This is the total present value of all the future cash flows. To calculate it, you apply the discount rate to the net cash flow during each year and sum them all up.
Here’s an example where IRR is used. Say a company uses two discount rates: 10% and 36%. At 10%, the NPV is $44,915 and at 36%, the NPV is negative $4820. Using the formula, the IRR would be:
(10% + (26% x 44,915))/49,735 = 33.48%
This figure can then be compared to the cost of capital to decide whether or not to go forward with the investment. The investment is worth making only if the cost of capital is lower than the internal rate of return.