The definition of Internal Rate of Return (IRR) is the rate of return provided by an investment, considering the percentage of loss or profit that said business will have for the amounts invested.
It is a meter used in the evaluation of investment projects closely linked to the Net Present Value. It is also considered as the value of the discount rate that makes the NPV equal to zero.
Thanks to the concept of Internal Rate of Return, we will be able to know when an investment is profitable or not. The result is reflected in a percentage.
Calculate the Internal Rate of Return
One of the greatest difficulties is found when calculating the IRR, where the number of periods will facilitate the order of the equation to be solved. A computer program or a financial calculator can be used.
The best definition of the IRR calculation is the discount rate that, at the initial moment, equals the future stream of collections with that of payments, achieving a net present value equal to zero.
IRR Calculator (Internal Rate of Return)
Advantages of the Internal Rate of Return
Among the main benefits of IRR to consider are:
- It is very valid for analyzing investment projects since it provides us with the profitability of said investment.
Disadvantages of the Internal Rate of Return
- It does not ensure the allocation of a return to the different investment projects and has mathematical solutions that do not make much financial sense, with projects with no 'r' or projects with several positive and real 'r'.
- Intermediate cash flow reinvestment hypothesis: represents that positive net cash flows are reinvested at 'r', while negative flows are financed at 'r'.
Example of Internal Rate of Return
Imagine that we invest 6.000 euros in a project that they offer us and guarantee a return of 3.000 euros in the first year and 4.000 in the second after the investment. The cash flows would be -6000/3000/4000.
The calculation of the IRR will lead us to equal the NPV to zero.
VAN = -6000 + (3000/1 + r) + (4000 / (1 + r) ª = 0 euros