Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is the minimum discount rate. Management use IRR for the identification of the capital investment or future project that they yield an acceptable return or not.
For the specific project, internal rate of return equate the net present value of future cash flow from project to Zero.
IRR has an algebraic equation. The internal rate of return formula can be calculated by the sum of present values of future cash flow and subtract the initial investment from the result in order to get zero value as
In the above equation, IRR is the rate which is not known by the management. Management will know how much amount require for the start of the project and have the estimate of the future income of investment Fr solving the discount rate we need to make equal NPV to zero.
Jerry has the shop of machines and wants to purchase the new machines. He is not sure to use the funds of the company in the better way at the present time. He bought a new machine of 100,000 dollars after that he will be able to take an order of which make the review of 20,000, 30,000, 40,000 and 40,000 dollars. Now we calculate the minimum rate of Jerry. Isolation of the discount rate is so difficult for which we need IRR calculator. For this, we need the approximate rate and we start at 8 per cent.
Our ending VPN is not equal to zero now increase the estimate internal rate to 10 and calculate again
Here the ending VPN is equal to 0 so the internal return rate of Jerry on this project is 10 per cent.
The internal rate of return is the rate at which net present value of investment cost equal to the expected future revenue of the company. Management of the company compares this rate with other investment opportunities to analyze that which is the best for investment.
If we take the above example of jerry’s machine and assume that Jerry invests in three types of machine. All the types have a different job and give different revenue to Jerry. Jerry compares IRR for all type and chooses that type which has the highest IRR.
Expected future cash flow not always be equal to the actual cash flow but this gives the power of decision making to management for their investment.
For more Financial Ratio Check:
Learn about Financial Ratios, Banking and Finance and feel better.