What is Internal Rate of Return

The actual rate of return earned on a project is called Internal Rate of Return (IRR). The Internal Rate of Return is the discount rate where the total present value of cash outflows equals the total present value of cash inflows. For projects with equal cash flows, a payback calculation can be used to find the IRR. If projects have varying cash flows over the life of the project, a trial and error approach must be used. However, most spreadsheet programs include an IRR formula which makes the calculation very simple.

Example: We have a project with an initial cash outlay of $ 40,000 and cash inflows each year are $ 10,000 over the next five years.

$ 40,000 / $ 10,000 = 4.0 factor, look up the 4.0 factor under Present Value of Annuity Table, across for periods = 5, we find 3.993 under 8%. The Internal Rate of Return is approximately 8%.

Using Microsoft Excel Spreadsheet: Enter all cash outflows and inflows into cells A1 to A7: - 40000, +10000, +10000, +10000, +10000, +10000. Make sure you enter your amounts in the correct order. From the menu bar, click Insert / Function / Financial / IRR into a separate cell. The formula should appear as =IRR(A1:A7).

It should be noted that IRR is probably the most popular economic criteria for evaluating capital projects. IRR is best used in conjunction with other economic criteria, such as Net Present Value and Discounted Payback.