Question

How do you calculate IRR for an investment

Answer 1

Internal rate of return or IRR is a method used in capital budgeting to estimate the profitability of potential investments . IRR is a discount rate that makes the Net present value (NPV) of all cash flows from a particular project equal to zero.

Decisions based on IRR

In theory, any project with an IRR greater than its cost of capital is a profitable one, and thus it is in a company’s interest to undertake such projects. In planning investment projects, firms will often establish a Minimum acceptable rate of return(MARR) to determine the minimum acceptable return percentage that the investment in question must earn in order to be worthwhile. Any project with an IRR that exceeds the RRR will likely be deemed a profitable one, although companies will not necessarily pursue a project on this basis alone. Rather, they will likely pursue projects with the highest difference between IRR and RRR, as these likely will be the most profitable.

Always remember cost of capital or MARR is minimum return expected by the providers of capital like equity, preference shares and loans in other word MARR is WACC of a project.

So naturally if IRR is more than MARR the investment would be profitable meaning we would earn more than the expectations of providers of capital signaling that we would repay their expected return easily and earn over and above it.

Calcuation of IRR

For IRR calculation first we calculate NPV of the project suppose NPV is $2000 at discount rate of 10% Note this discount rate is MARR or cost of capital. Now this is positive NPV Now again we will calculate NPV again but this time we would try to find Negative NPV using a higher discount rate say 15%. therefore discounting at 15% suppose NPV is -$1000. Now we have 2 NPVs one positive of 2000 and one negative of -1000. and 2 discount rates of 10 and 15% therefore IRR lies between these 2 rates as NPV of Zero would fall between positive and negative NPVs.

Formula for calculating IRR using interpolation formula is as follows

Lower rate + NPV at lower rate /NPV at lower rate - NPV at higher rate * ( Higher rate - lower rate)

In my example above putting values we have 10% + 2000/2000- (-1000) * (15-10) = 10% + 2000/3000 * 5= 10% + 10000/3000= 10 + 3.33= 13.33 % so IRR at 13.33% means at discount rate of 13.33% we have NPV = zero.

Calculation of NPV = Pv of cash outflows - Pv of cash inflows Generally Pv of cash outflows is equal to intial investment as investment is made at the beginning of the project (year 0) and PV of year 0 is always 1.

Take a look at example in the excel image to understand better