Companies use many formulas for calculating the return on an investment and one of the more common formulas is the internal rate of return (IRR). The thing about IRR is that you really do not calculate it as much as you guess what it could be and then use a formula to confirm your guess. When you look at the spreadsheets of any business owner, you will usually see at least one sheet filled with numbers dedicated to the IRR.
What Is IRR?
The IRR is an interest rate that represents the best possible return for any investment. If you are not an accounting expert, then it is best just to trust the formulas when determining IRR because it can be difficult to understand. For example, while calculating the IRR you may find that a return of six percent is much better than 10 percent. It would take years of accounting and economics classes to truly understand how it works, but it is not nearly as difficult to show someone how to calculate IRR.
Present Value (PV)
Calculating IRR starts with calculating present value (PV). The present value determines how much an investment that is completed months or years later is worth in today’s dollars. This gives investors or business owners a good idea as to the strength of their investment.
As an example, let us say that you get the chance to invest $100.00 now to get $115.00 in return in one year. As a control, you use an interest rate of 10 percent. The formula for PV is:
PV = Return / (1 + Interest Rate) ^ Number of Years
In this case, it would be:
PV = 115 / (1 + 0.10) ^ 1
PV = $104.55
Net Present Value (NPV)
The net present value (NPV) is the difference between the initial investment and the PV. A good investment is one that makes the NPV zero. The formula for NPV is:
NPV = PV – Initial Investment
In this case, the NPV would be:
NPV = $104.55 – $100.00
NPV = $4.55
When you get a positive number, then it is a decent investment. If you get a negative number, then it is a terrible investment. But when you get zero, then you are getting the ideal investment.
The IRR is the interest rate that makes the NPV zero. In this example, we know that 10 percent is not the IRR because it did not make the NPV zero. To find the IRR that works for you, it is just a matter of replacing the interest rate until you find one that makes the IRR zero.
If we try nine percent, we get an NPV of $105.50. Lowering the interest rate makes the NPV higher. If we try an interest rate of 12 percent, we get an NPV of $102.68. While that gets us closer to zero, you might not think it is close enough. One more calculation using a 14 percent interest rate gets us an NPV of $100.88, which we determine to be close enough. In this instance, our IRR is 14 percent. You may choose to add some decimals until you get to exact zero, or you can go with 14 percent.
The IRR is a subjective interest rate that can vary depending on the situation. Calculating the IRR shows business owners how different interest rates affect their investments and can help to project a more accurate return on investment.