Internal Rate of Return

IRR is a metric used in capital budgeting to analyse the profitability of potential investments. To fully understand its meaning, we must first grasp the concept of Future Value, Present Value, Net Present Value and Discount Rate (r).

Say if today’s value of $1,000.00 in 10 years’ time, will have a lesser value of $613.87 ( $1,000.00/ 1.05^10 ) if the discount rate is 5% throughout this period. Looking at it from today’s time frame, then the $613.87 is the Present Value of the $1,000.00 banknote kept after 10 years. In another words, today’s Present Value of $613.87 is equal to $1,000.00 of 10 years later’s value. That $1,000.00 is the Future value.

To understand the concept of Net Present Value, we ought to force the total positive cash inflow equal to the total negative cash outflow for the entire project cycle, only by adjusting the Discount Rate. Notice that it is in the reference of the Present Value for the project cycle. Please see the spreadsheet on the right under the heading “Total cash flow ( Present value) “,  the bottom most  figure, which is zero, is the sum of the first negative cash flow and the subsequent positive cash flows throughout the 25 years.

Finally, notice that the Discount Rate r, is the only variable able to balance the two cash flows, (inflow & outflow) by adjusting to the optimum value. That optimum value of r, is actually known as the Internal Rate of Return, IRR. In this example, r is 32.05%.

IRR is often viewed as the interest rate, in which is to be compared with the cost of borrowed fund.