How to Calculate IRR in 7 Steps (Plus Definition and Limits)

By Indeed Editorial Team

Published 19 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

The internal rate of return (IRR) is a calculation that helps you estimate the profit margins of investments. Financial analysis professionals can use this formula and calculation to help a business estimate its potential profits if it were to invest money into something, such as funds, security or bank deposits. Learning how to calculate the IRR may benefit your career in the finance and investment industries and ensure a company's investments are profitable. In this article, we define what IRR is, discuss how to calculate it, describe when to use IRR and discuss the limitations of this calculation.

What is IRR?

An IRR is a metric used to estimate an investment's percentage rate of return, primarily for companies and organisations to determine the profitability of potential investments. IRR is also a discount rate, which means it refers to the interest rate to determine the present value of future cash flow. Additionally, the higher the IRR, the more desirable it is as an investment. The IRR is the interest rate that makes the NPV equal to zero. The NPV is how much the investment is worth in today's money.

When deciding on an investment to pursue, organisations might choose the ones with higher IRRs and consider it as the best option for them, because they can earn more revenue coming back into the business than losing money in the investment.

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How to calculate IRR in 7 steps

You can learn how to calculate IRR through trial and error to determine the best IRR for an investment. For those who use IRR to determine the profitability of investments, there are many tools, such as spreadsheet software programs and calculators, that use the IRR formula to experiment with numbers efficiently. These tools can help produce a variety of IRRs based on changing factors to determine the best IRR for an organisation. Here's the formula for IRR:

0=CF0+CF1/ (1+IRR)+CF2/ (1+IRR)2+CF3/ (1+IRR)3...+CFn/ (1+IRR)n

Here's what each letter and number represents for you to plug into the formula when you're calculating:

  • CF0 = initial investment / outlay

  • CF1, CF2, CF3...CFn = cash flows

  • n = the holding period

  • IRR = internal rate of return

Here are the steps you can follow to calculate an investment's IRR:

1. Break the cash flow

The first step in calculating the IRR is to break the organisation's cash flow into periods. A cash flow is the net amount of cash and cash alternatives transferred in and out of a company. The net amount means the amount of cash and cash alternatives a company has left over after the deductions are subtracted, such as taxes. You can break the organisation's cash flow into a period, such as per month, per quarter or another time frame, that makes sense and meets the needs of the company.

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2. Determine the standard cash flow

After you've divided the cash flows into periods, you can determine the standard cash flow for each of those periods. In the formula, place that number in its respective places. To find a company's standard cash flow, you may find the number on the financial statements for the organisation. The financial statement helpful to find this number is on a company's cash flow statement. A cash flow statement is a financial document for a company detailing changes in the balance sheet and the amount of cash and cash equivalents entering and exiting a company.

On the financial statement, add the cash flows together from each year. Once you find the sum of the cash flows, divide it by the number of cash flow years. This gives you the annual cash flow average for the company.

3. Divide each period's cash flow

Once you've found the annual cash flow average, divide each period's cash flow by 1+IRR. For each period, select a percentage of the organisation's desires to aim for. Use the decimal form of the IRR plus one and divide cash flow by that number to determine each period's earnings.

4. Identify an initial investment number

The next step is to identify an initial investment number to use. The initial investment, or initial outlay, is the total number required for starting a new business or a project. This number is equal to the capital expenses added to the capital requirements after the tax deductions. Subtract the initial investment sum from the cash flow and then divide by the IRR plus one.

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5. Subtract other company's expenses

It's helpful to identify and subtract other expenses a company has as it completes an investment. Other expenses of a company can include employees' salary and benefits, office equipment and business insurance. You can find an itemised list of a business' expenses in an income statement. To find the company's expenses, subtract the net income from the total amount of revenue.

6. Solve for the net present value (NPV)

An NPV is a difference between the present value cash flows and cash outflows on a project compared to the initial investment. After you subtract the total amount of business expenses, solve for the NPV of 0. This number may ensure the investment is equal to the assumed rate. Additionally, this formula is about projection, which means the numbers may change due to market value and other unexpected costs or challenges. Here's the formula you can use when solving for the NPV:

NPV = Rt / (1+i)t

Here's what each letter and number represents for you to plug into the formula when you're calculating:

  • NPV = net present value

  • Rt = net cash flow at time t

  • i = discount rate

  • t = time of the cash flow

7. Experiment with IRRs and cash flow

You may find it beneficial to experiment with the IRRs and cash flow to determine the highest IRR. As the organisation manages investment opportunities, use tools to customise the values in this formula to ensure the investment remains profitable. The types of tools you can consider helping you with determining the highest IRR for a company can include computer spreadsheet software programs or calculators. The calculators you may find helpful are ones online that are free and have a specific use for determining the IRR or you can use a manual one, either physical or digital.

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When do you use IRR?

IRR is most commonly used to compare the profitability of expanding existing operations versus establishing new ones. For example, a manufacturing company may use IRR to decide whether to expand its current plant or to open a new manufacturing plant altogether. While both decisions might allow the company to grow its operations, one may be the more logical decision once management sees what the internal rate of return is for both.

Additionally, a company can calculate its IRR to help make informed financial decisions for the organisation. An example of the type of financial decision a company can consider is when determining the type of insurance policies to offer its employees. If a policy has the same amount of premiums and a higher IRR, companies may choose those insurance policies over others with a lower IRR.

Limitations of IRR

There are some limitations you might encounter when using the formula to calculate the profitability of a company's investments. One limitation you may find is that the IRR doesn't define the initial return on investment in real dollars. For example, you may find the IRR is 20%, but the calculation doesn't define the total dollar amount of the percentage. This means your IRR might be 20% of 20,000 or 200,000 AUD. Additionally, IRR assumes a company reinvests its positive cash flows at the exact rate as the other projects, rather than a company's cost of capital.

The cost of capital is an organisation's calculation for the minimum return required to justify spending a certain amount of money on a new project. This means the IRR might not reflect the profitability and the cost of a project accurately. To help you avoid some limitations of this formula, you can use a modified internal rate of return (MIRR). MIRR can help you determine the expected profits and cost of projects with more accuracy and assumes a company reinvests all of its positive cash flow into the cost of capital. Here's the formula for MIRR you can use:

MIRR = (Future value of positive cash flows / present value of negative cash flows) (1/n)–1

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