Welcome to Alanis Business Academy.
I'm Matt Alanis and this is How to Calculate the Internal Rate of Return.
Often referred to by the acronym IRR, the internal rate of return is a common tool used
to assist firms in evaluating various capital budgeting proposals.
Put simply, these firms are attempting to determine the best use of their limited resources.
Before we calculate the IRR it's important that you have a knowledge of the time value
of money as well as how to calculate the net present value.
For a refresher on these topics select the links above and then come back to this video
once you feel confident that you can carry out the net present value calculations.
IRR is the discount rate that causes the net present value or NPV to equal zero.
A NPV of zero essentially means that the present value of all future cash flows equals the
value of our investment.
Put another way, the money that we expect to receive in the future, discounted into
todays value, equals how much money we are investing in this project.
By obtaining the IRR for several projects we can determine which project is most likely
to provide a better return.
A higher IRR means that we have to discount our future cash flows by a greater interest
rate so that they equal our investment.
As a result, projects that yield a higher internal rate of return are considered to
be more attractive compared to there lower yielding counterparts.
In order to calculate the IRR we need to go through a trial and error process utilizing
the present value formula.
As an example, lets say that you're planning on investing $5,000 in a project that is expected
to produce $2,500 in cash at the end of the year 1 and $3,500 in cash at the end of the
year 2.
What is our expected internal rate of return?
To answer this question it helps to first draw out our scenario as follows.
Next, we need to select an interest rate that we feel may cause future cash flows to be
worth $5,000 after being discounted.
Remember this is trial and error so don't worry to much about having to repeat the process.
Lets start with a discount rate of 9 percent.
At this point we essentially work through the problem as if we're attempting to determine
the NPV.
You can either use the present value equation, which is PV equals FV divided by 1 plus i
to the nth power, a financial calculator, or software like Microsoft Excel.
I'm going to utilize the PV equation.
After discounting $2,500 by our discount rate of 9 percent for one year we receive a present
value of $2,293.58 after rounding to the nearest hundredth.
After discounting $3,500 by our discount rate of 9 percent for two years we receive a present
value of $2,945.88.
Next we add both figures together to get $5,239.46.
Since our discounted future cash flows are $5,239.46 and our investment is $5,000, an
IRR of 9 percent gives us a NPV of $239.46, which of course is greater than 0.
A positive NPV tells us that we need a higher discount rate to lower the present value of
our future cash flows.
So lets select a higher discount rate.
For our next calculations lets use a discount rate of 12 percent.
Once again I'm going to draw out our scenario and then use the present value equation to
discount our future cash flows.
$2,500 discounted by our discount rate of 12 percent for one year gives us a present
value of $2,232.14 rounded to nearest hundredth.
$3,500 discounted by our discount rate of 12 percent for two year gives us a present
value of $2,790.18 rounded to the nearest hundredth.
Adding these two figures together gives us a total present value of $5,022.32.
This is very close to our investment of $5,000 and would result in a NPV of only $22.32.
Although this isn't zero, what this tells us is that we're only fractions of a percent
away from our IRR.
You can continue to go through this trial and error process to obtain the exact IRR
if you wish.
Using a financial calculator, which is far less time consuming, we receive an IRR of
12.32 percent.
This has been How to Calculate the Internal Rate of Return.
If you have any questions or comments please leave them in the comment box below and I'll
do my best to get back to those in a timely fashion.
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