7.13 : Calculating Internal Rate of Return

The internal rate of return, or IRR, is the expected compound annual rate of return on a project or investment.

Consider an example of an electronic manufacturing company's project to calculate the IRR.

The company is considering a project that requires an initial investment of a hundred thousand dollars and expects to generate annual cash flows of thirty thousand dollars for the next five years.

IRR is mathematically represented using the net present value formula.

The net present value is taken as zero, and r is calculated using a trial and error method or financial software.

The net present value of the project is approximately thirteen thousand seven hundred twenty-four dollars when the rate is ten percent per annum.

The calculated IRR for the company's project is approximately fifteen point two four percent, which makes the NPV of all cash flows from a project equal to zero.

If the company proceeds with the investment, it can expect to earn an annual return of fifteen point two four percent on its initial investment, based on the projected cash flows.