How to calculate internal rate of return

The internal rate of return (IRR) is a crucial metric in finance that helps to evaluate the profitability of an investment. It is the discount rate that makes the net present value (NPV) of all cash flows from a particular investment equal to zero. In other words, it is the rate at which the present value of all future cash flows from the investment is equal to the initial investment cost. To calculate the internal rate of return, you can use the following steps: 1. List all the cash flows: Identify all the cash flows associated with the investment, including the initial investment (negative cash flow) and any subsequent cash inflows or outflows. 2. Set up the IRR formula: The IRR formula is used to find the discount rate that makes the NPV of the cash flows equal to zero. The formula is: 0 = CF0 + CF1 / (1+IRR) + CF2 / (1+IRR)^2 + ... + CFn / (1+IRR)^n where CF0, CF1, CF2, ..., CFn are the cash flows at time 0, 1, 2, ..., n. 3. Use trial and error or a financial calculator: Since the IRR formula is non-linear, it is often solved using trial and error or a financial calculator. In the trial and error method, you can try different discount rates until the NPV of the cash flows is close to zero. Alternatively, you can use a financial calculator or software that has a built-in IRR function to compute the IRR directly. 4. Interpret the IRR: Once you have calculated the IRR, you can interpret it to determine the profitability of the investment. If the IRR is higher than the required rate of return or the cost of capital, the investment is considered attractive. If the IRR is lower than the required rate of return, the investment may not be worthwhile. It's important to note that IRR has its limitations and may not be suitable for all investment evaluations, especially in cases where cash flows change sign multiple times. Nevertheless, it is a widely used metric in finance for comparing the profitability of different investment opportunities.