The internal rate of return (IRR) is a measure of the rate of return that is expected on a project or investment. It is the discount rate that makes the net present value (NPV) of all cash flows from a project or investment equal to zero. In other words, it is the expected annualized rate of return that will be earned on a project or investment.
Here is an example to illustrate how IRR works:
Suppose you are considering investing in a project that has an initial cost of $100 and is expected to generate cash flows of $50 at the end of year 1, $60 at the end of year 2, and $70 at the end of year 3. To calculate the IRR for this project, you would first need to determine the NPV of the cash flows at different discount rates. For example, if the discount rate is 10%, the NPV of the cash flows would be:
- $100 + ($50 / 1.1) + ($60 / (1.1)^2) + ($70 / (1.1)^3) = $100 + $45.45 + $36.60 + $27.85 = $210.90
If the discount rate is 20%, the NPV of the cash flows would be:
- $100 + ($50 / 1.2) + ($60 / (1.2)^2) + ($70 / (1.2)^3) = $100 + $41.67 + $27.78 + $20.25 = $190.70
To determine the IRR for this project, you would need to find the discount rate that makes the NPV of the cash flows equal to zero. In this case, the IRR would be approximately 16.22%. This means that, if the project is completed, you can expect to earn an annualized rate of return of 16.22% on your investment.