Internal rate of return is commonly known as IRR by those in the

financial industry. To understand internal rate of return, you must

first know what is NPV or net present value. IRR is discounted rate

of return derived based on the condition that net present value for

an investment is 0. IRR is then compared to the company’s discounted

rate of return. If IRR is higher than the company’s / project’s discounted

rate of returns, then the investment is deemed to be worthwhile for the company or investor.

The discounted rate of return for the company is determined

by the investors themselves. Discounted rate of return is derived

based on a number of factors. One of them is the consideration of

risk. If the investor is evaluating a more risky investment, he is

likely to have a higher rate of return. This is to compensate the risk

that he is taking on this project. Another factor that could influence

the discounted rate of return is the general market rate of return.

To calculate the internal rate of return manually (without a

financial calculator) is a very laborious process. It will take

you minutes if not hours. However, using Excel, you can do it in

less than a minute. Assuming that the cash flows (from year 0 to

year 5) is in the range “D$3:J$3″, the formula to derive the IRR

is “=IRR(D$3:J$3)” without quotes.

Now that we have learnt how to calculate the internal

rate of return, it is important to know that IRR can only be

used under certain conditions. The best way to determine if the

IRR can be used is to plot the NPV of the investment against

the discount rate of return. If the NPV crosses the X-axis more

than once, i.e. NPV is zero more than once, than the investment

is considered to have multiple internal rate of return and should

be used with caution.

It is very safe to use IRR only when the cash inflow or outflow only

changes once. This means that you can have a series of outflow

before the inflow comes in. Once the inflow kicks in, outflow cannot

be present again. Alternatively, you could have a series of inflow

first followed by a series of outflow, but inflow of funds cannot

appear again. If there are multiple IRR, then it would be difficult

to determine which IRR to use.

If there are changes in the cash flows from negative to

positive and back again to negative, the chances of this

investment having multiple internal rate of return is very

high.

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