What is the internal rate of return (IRR) and how is it calculated?

The internal rate of return (IRR) is a financial metric used in capital budgeting to evaluate the profitability of an investment project. It represents the discount rate at which the net present value (NPV) of the project becomes zero. In other words, it is the rate of return that makes the present value of the project's cash inflows equal to the present value of its cash outflows.

To calculate the internal rate of return, the following steps can be followed:

1. Identify the expected cash inflows and outflows associated with the investment project over its lifespan.
2. Estimate the initial investment cost (negative cash outflow) and subsequent cash inflows (positive cash inflows) for each period.
3. Determine the appropriate discount rate to be used. This rate is often based on the cost of capital or the required rate of return for the project.
4. Use a trial-and-error approach or financial software to find the discount rate that results in a net present value of zero. This is the internal rate of return.
5. Alternatively, the IRR can be calculated using the formula:

IRR = Initial Investment Cost / (Cash Inflow Year 1 / (1 + IRR)^1 + Cash Inflow Year 2 / (1 + IRR)^2 + ... + Cash Inflow Year n / (1 + IRR)^n)

Where n represents the number of periods and IRR is the internal rate of return.

Once the IRR is calculated, it can be compared to the required rate of return or the cost of capital. If the IRR is higher than the required rate of return, the project is considered financially viable and may be accepted. Conversely, if the IRR is lower than the required rate of return, the project may be rejected as it is not expected to generate sufficient returns to cover the cost of capital.