Internal Rate of Return (IRR)

The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discounted rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

IRR is ideal for analyzing capital budgeting projects to understand and compare potential annual return rates over time. To calculate the IRR, first, you need to equal the net present value to 0:

0 = NPV = Σ Ct/(1+IRR)^t − C0

where: Ct =Net cash inflow during the period.

C0 = Total initial investment costs.

IRR = The internal rate of return.

t = The number of periods.

As complicated as this formula seems, you can also calculate the IRR using OpenOffice Calc or Microsoft Excel. All you need to do is combine your cash flows, including the initial outlay and subsequent inflows and apply the IRR function.