The IRR is the discount rate that makes a project or investment's Net Present Value (NPV) equal to zero.

For instance, consider a renewable energy company evaluating a project that requires an initial investment of $200,000, with expected annual cash flows of $50,000 over the next six years.

To determine the IRR for this project, the NPV is computed for different rates on a trial-and-error basis using a financial calculator or an Excel spreadsheet.

  1. At a 10% discount rate, the NPV is $17,763, meaning the IRR can go higher than this.
  2. At a 12% discount rate, the NPV is approximately $5,570, which is still positive but close to zero. This suggests that the IRR is slightly higher than 12%.
  3. At a 13% discount rate, the NPV is—$122, which is negative and closer to zero and implies that the IRR is slightly lower.
  4. At a 12.978% discount rate, the NPV is zero, making it the correct internal rate of return for this investment.

Based on these projected cash flows, if the company proceeds with the investment, it can expect an annual return of 12.978%.

Del capítulo 7:

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