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It’s simple to use the IRR calculator: simply enter the original investment (tool says dollars, but it can be in any currency like EUR, Swiss francs, etc.) then choose how many years of cash flow you want to look at (could be any period, actually, but maximum 25 periods). For each period, enter the cash flow (past or future prediction).
When you’re ready, hit “Calculate,” and our Internal Rate of Return calculator will give you the following results:
The Internal Rate of Return (IRR) is a discount rate (interest rate) that equalises the net present value (NPV) of all cash flows from a project. It’s also known as “discounted cash flow rate of return” and “economic rate of return.” The term “internal” refers to the absence of external elements like capital costs, currency inflation, and so on. It gives earlier cash flows more weight than later cash flows by definition, reflecting the temporal preference of investors.
The internal rate of return (IRR) is used to measure the profitability of possible investments: the higher the IRR, the more desirable the project is, whereas the lower the IRR, the more hazardous and generally undesirable the project is. It’s frequently used to rank potential projects on a level playing field.
In general, IRR should be combined with other metrics like NPV. It should be used with caution, as comparing it across projects with vastly varying estimated durations might be deceptive. Another factor to consider is that IRR does not account for reinvestment rates, which are more closely related to capital costs. When cost of capital must be considered, some suggest using the modified internal rate of return (MIRR).
If you’re wondering how to calculate the Internal Rate of Return on your own or using an Excel spreadsheet, you’ll be startled to learn that there is no analytical method and that the only way to do it is programmatically or with tools like our IRR calculator. The NPV formula is still in use:
C0 is the initial investment, and Ct is the return during period t, where r is the discount rate / interest rate and t is the number of cash flow periods. One must substitute zero for NPV and solve for r, for which there is no analytical solution because r cannot be isolated in one side of the equation. As a result, our calculator conducts a recursive search until it finds a r number that produces an NPV near to zero.
Consider the following scenario for an investment: An initial investment of $10,000 is required for a project that is predicted to return $15,000 in three years, with positive cash flows of $3,800, $4,400, and $6,800 in each year. What is the internal rate of return on your investment? The value of the discount rate at which the net present value becomes zero, according to the definition of IRR. Examining the link between the present value and the discount rate (also known as the cost of capital) graphically is one technique to tackle this problem:
We can observe from the graph that the NPV changes from positive to negative when the discount rate is between 20% and 21%. The next step is to try to approximate the internal rate of return by experimenting with different discount rates in that range until the PV is extremely close to zero. The answer is 20.9 percent in this situation.
While the visual description in the above example is helpful in grasping the concept of IRR, in practice, it is preferable to use a software application to automate the process.
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