The Internal Rate of Return (IRR) is an equation to determine the profitability of investments undertaken by a business. This process requires some trial and error as well as a firm grasp of the time value of money. The theory of the time value of money states that a dollar today is worth more than having a dollar a year from now because you can invest the dollar now and “grow” the investment based on the interest that dollar earns.
Determine the initial investment. When a business undertakes a new investment, the funds are used for things such as purchasing assets and hiring new employees. To determine the underlying value of these assets, review the business’s financial statements. A detailed balance sheet should provide you with the value of the assets acquired to undertake the project, and a detailed interest statement will provide you with the new costs associated with hiring and training employees for the project. The sum of all of these expenditures will equal your initial investment.
Estimate cash flow projections for the new business activity. The other side of the IRR equation is how much income the activity is projected to generate. The projected cash flows must be generated by the assets you identified on the balance sheet. For example, if you are introducing a new product line that should earn income over five years, determine how much it will earn each year, with $200 in the first year, $150 in the second year and so forth.
Establish the basic discount factor for each year of projected cash flows. The discount factor is the number 1 plus IRR raised to the power defined by how many years in the future the cash flow will be earned. For example, a cash flow earned three years from now would be calculated as 1 plus IRR raised to the third power.
Calculate IRR using the cash flow projections and initial investment. The correct IRR occurs when the discounted value of future cash flows equals the initial investment. Each year of discounted cash flow is calculated by dividing the projected cash amount for that period by the discount factor. After establishing these basic equations, substitute different possible IRRs until the sum of the discounted cash flows equals the initial investment.
This calculation is generally compared to a company benchmark, such as a business’s Weighted Average Cost of Capital (WACC), to determine if a project would be profitable for a business undertaking the project. When calculating IRR, consider using a spreadsheet program, as it will allow for an easier trial and error process.