Calculation Formula of Internal rate of return and its Application

Internal rate of return (Internal Rate of Return)Kastkingsharky34000IRR) is an important index to evaluate the profitability of investment projects. It is the discount rate that makes the net present value (Net Present Value, NPV) of the investment project equal to zero. In other words, IRR is the growth rate that investors expect to recover from an investment project without considering the value of time. Understanding the calculation formula and application of IRR is of great significance for investors to make scientific and reasonable investment decisions.

The calculation formula of IRR

Suppose an investment project has N periods, and the return on each period is CF_t.Kastkingsharky34000.Kastkingsharky34000.., N), the initial investment cost is CF_0 (usually negative), then the internal rate of return IRR can be obtained by the following formulaKastkingsharky34000:

The formula explains that the discount rate of 0 = Σ (CF_t / (1 + IRR) ^ t)-CF_0 net present value (NPV) equals 00:00 is IRR.

Because the calculation of IRR involves solving univariate N-th equation, it usually needs to be solved with the help of financial calculator or spreadsheet software (such as Microsoft Excel).

Practical Application of IRR

When making investment decisions, investors usually compare the IRR of different projects and choose projects with higher IRR to invest. In addition, investors can also compare IRR with their own cost of capital to determine whether the investment project has enough profit space.

For example, a company plans to invest in two projects An and B. the IRR of project An is 15% and the IRR of project B is 12%. If the company's own cost of capital is 10%, the company may give priority to investment project A because its rate of return is higher than that of project B and has higher profit space.

In addition, IRR can be used to assess the interdependencies between projects. When there is a complementary relationship of resources, technology or other aspects between two projects, the IRR of the combined project can be calculated to evaluate the profitability of the overall investment.

It should be noted that although IRR has important reference value in investment decisions, it is not omnipotent. In some special cases, such as the unstable cash flow of the project, the alternation of multiple positive and negative cash flows, IRR may not be able to accurately reflect the real income of the project. At this time, investors can also combine other financial indicators (such as net present value, investment payback period, etc.) to conduct a comprehensive evaluation.