The internal rate of return (IRR) is another calculation for evaluating the value to shareholders of potential project investments. The IRR represents the actual rate of return earned on an investment. The idea of IRR is to find the discount rate that will make the net present value of the cash flows equal to the initial investment. We start with the NPV formula.

NPV = CFt[1 / (1 + R)]t­ CF0

To calculate the IRR, we set the NPV to 0 and solve for R (the internal rate of return for the investment). As you can see, this can be very difficult, especially if T (the number of cash flows) is quite large. The formula looks like this:

O = CFt[1 / (1 + R)]t ­ CF0

Finding IRR
with a financial
calculator

Most financial calculators can handle this calculation. The method is to input the cash flows in the proper order (remember to enter CF 0as a negative number) and push the IRR key. Check your owner's manual for the specifics.

Try the following example using your calculator.

Example

An investment requires an initial investment of $2,000 and will pay $1,000 at the end of the next three years. Calculate the investment's internal rate of return (IRR). Enter the cash flows into your calculator, CF 0 = -$2,000 and CF1, CF2, and CF3 = $1,000 each. Now push the IRR key and you should get IRR = 23.38%

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