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Internal Rate of Return Formula

About Internal Rate of Return Formula

The interest rate that makes the net present value zero is known as the internal rate of return (IRR), sometimes known as the discounted cash flow rate of return (DCFROR). The internal rate of return (IRR) formula is used in capital planning and corporate finance to determine which discount rate will make the original cost of a capital expenditure equal to the current value of future cash flows post-tax. The name "internal" refers to the fact that this technique of calculating rate excludes external elements like inflation, risk-free rate, cost of capital, and any financial concerns.

What do you mean by Internal Rate of Return Formula?

  • The Internal Rate of Return (IRR) is calculated using a trial and error method along with the Net Present Value formula (NPV). IRR, or the rate for which net present value equals zero, is calculated using the internal rate of return formula. The internal rate of return formula is as follows:
    • 0 = ∑n-1NCFn/(1 + IRR)n
  • The formula for the internal rate of return is as follows:
  • Where,
    • N = Total number of time periods
    • n = Time period
    • CFn= Net cash flow at time period
    • IRR = Internal rate of return

Internal Rate of Return Formula Calculation Rules

When calculating the internal rate of return formula, there are a few things to keep in mind. They are:

  1. Set the NPV to zero and find the discount rate (also known as the internal rate of return).
  2. Because it is an outflow, the initial investment is always negative.
  3. Each succeeding cash flow may be positive or negative, based on the project's expected cash flow in the future.
  4. Instead of using an analytical way to compute IRR, employ a more technical method such as excel.

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