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IRR Calculation Part 1
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- Rate of return is “how fast” you can get back your money after you invest it. It’s expressed as a percentage per year, forever.
- For example, if you invest $100 and get back $3 per year (forever), then your rate of return is 3% (Because $3 = 3% of $100)
- Internal rate of return is the same as rate of return, except it’s not so easy to figure out like in the $3 example above. What if you get back $3 on the first year, but another amount in other years? And what if it’s not forever?
- In this case, we figure out this “mystery” rate of return (a.k.a. internal rate of return) using the IRR or Internal Rate of Return Formula:
0 = CF1(1+irr) + CF2(1+irr)-1 +…+ CFN(1+irr)-n
DON’T panic! It’s much EASIER than it looks. Watch tutorial video below.
- IRR is used to gauge how “profitable” a business is, taking into account the amount invested in a company or a specific project
- IRR can be compared to cost of borrowing money for capital (or other sources of capital). For example: if your company’s capital comes from borrowing money from the bank at 5% interest rate, then your IRR should be higher than 5%… if your IRR is only 3%, then you are losing 2% (because 3% IRR less 5% bank interest will leave you with negative -2%)
- IRR can also be compared to your alternative investment choices. Why will you do a business project and earn only 3% IRR… if you can instead invest your money in a bank’s fixed term deposit which earns 4%? You are missing an opportunity to earn an extra 1%.