The internal rate of return (TIR) is one of the indicators financial most commonly used to assess the return on investment. In practice, this is the interest rate at which the net present value of a project’s cash flows equals zero. In other words: it is the return offered by an investment, expressed as a percentage. Now, How do you calculate the internal rate of return?
Here’s a heads-up: performing the calculation isn’t easy, but in this post we’ll help you with some tips and practical examples. We’ll also explain the limitations of the IRR and how to interpret the result. Read on!
What is needed to calculate the internal rate of return?
Before we get started with the calculation steps, it’s important to know that the IRR is very useful for determining the minimum return you should require for an investment to be profitable. Furthermore, if you’re unsure whether or not to accept a project, the IRR can help you make decisions depending on whether it is greater than or less than cost the opportunity cost or the discount rate.
As for the calculation, we have some good news for you: there are software tools that make it easier to calculate the IRR, such as Excel, financial calculators or spreadsheet programmes. These tools usually have a specific function for calculating the IRR, which typically requires the following data:
- The initial investment amount, which is entered as a negative number, as it represents an outlay or expenditure.
- The cash flows expected returns on the investment, which are entered as positive figures, as they represent income or cash inflows.
- The number of periods over which the investment runs, which may be annual, monthly or quarterly.
In the following section, we explain the concept of the IRR and how to calculate it in more detail, using an example.
Example of calculating the internal rate of return
Let’s suppose we want to invest in a company which requires a initial investment of €50,000, which is expected to generate net profits of €15,000, €20,000, €25,000 and €30,000 over the next four years. What is the IRR of this investment? Let’s use the Excel IRR function To find out:
- In cell A1, enter the initial investment amount. Remember that it must be a negative number: -€50,000.
- In cells A2, A3, A4 and A5, we enter the net profits.
- The formula =IRR(A1:A5) is then entered into cell A6
The result Excel will give us for this formula is 0.2874. This is expressed as a percentage, that is to say, the The IRR for this investment would be 28.741%.
Below, we explain in more detail how to determine whether or not the investment is profitable.
Interpreting the internal rate of return
Once a project’s IRR has been calculated, the result must be interpreted to determine whether to accept or reject the project. To do this, the IRR must be compared with the opportunity cost or the discount rate, which is the minimum return expected from an investment.
In general:
- If the The IRR is greater than the opportunity cost, the investment is cost-effective and the project must be approved.
- If the The IRR is lower than the opportunity cost, the investment it isn't cost-effective and the proposal must be rejected.
- If the IRR is equal to the opportunity cost, the investment is indifferent and the project can be accepted or rejected.
To continue with the previous example, if the opportunity cost of this investment is 101, then the IRR is 28.741, meaning the project is profitable and should be accepted.
Drawbacks of the internal rate of return
Finally, we would like to point out that although the IRR is a widely used indicator, it does have some drawbacks that you should bear in mind:
- It may produce incorrect or misleading results when a project’s cash flows change sign more than once, i.e. when there are alternating inflows and outflows of cash.
- If projects of different durations or with different investment sizes are compared, the net present value results may be inconsistent or contradictory.
- The IRR assumes that the cash flows generated by a project are reinvested at the same interest rate as the IRR, which may not be realistic or optimal.
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