Calculating Internal Rate of Return
The internal rate of return, sometimes called the "yield criterion" or the "dollar-weighted rate of return," is a measure widely used to gauge whether an investment is worth pursuing, or in evaluating a number of investment opportunities. It is in effect the discount rate that equates the net present value of an investment opportunity with zero, since the present value of cash inflows equals the initial investment, and allows an investor to find the interest rate equivalent to the monetary returns expected from the investment. Once that rate is determined, it can be compared with the rates that could be earned by investing the money elsewhere, or to the weighted cost of capital. The internal rate of return also accounts for the time value of money. A rule of thumb is that the investment is feasible if the internal rate of return is greater than the cost of capital.
The measure can be applied to, for example, a project under consideration costing $7,500 that is expected to return $2,000 every year for five years, or a total of $10,000. The internal rate of return calculated for the project would be about 10%. If the cost of borrowing money for the project, or the return on investing the funds elsewhere, is less than 10%, the project is probably feasible. If the alternate use of the money will return 10% or more, the project should be rejected, since from a financial perspective it will break even at best.
Management usually demands an internal rate of return equal to or higher than the cost of capital, depending on relative risk and other factors.
The best way to compute an internal rate of return is by using a spreadsheet such as Excel, or a financial calculator. Both do the calculation automatically, although it is crucial to understand how the calculation should be structured.
In Excel, for example, select the internal rate of return function. This requires the annual cash flows to be set out in columns and the first part of the internal rate of return formula requires the cell reference range of these cash flows to be entered. Then a guess of the internal rate of return is required. The default is 10%, or 0.1.
Thus the internal rate of return is calculated very largely by trial and error. Many analysts prefer to calculate the Net Present Value when contemplating an investment. This is very much easier, since the Net Present Value equals the present value of cash inflows, minus the initial investment.
- Internal rate of return analysis is widely used to evaluate a project's cash flows rather than income, because, unlike income, cash flows do not reflect depreciation and therefore are usually more instructive to appraise.
- Most basic spreadsheet functions apply to cash flows only.
- The internal rate of return has critics who dismiss it as misleading, especially as significant costs often occur late in a project.
- The rule of thumb mentioned above—the higher the internal rate of return the better—does not always apply.
- For the most thorough analysis of an investment's potential, some experts advocate using both the internal rate of return and Net Present Value calculations, and comparing their results.
Economics Interactive Lecture: http://hadm.sph.sc.edu/COURSES/ECON/irr/irr.html