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The IRR (Internal Rate of Return) is a tool used by economists to calculate the return on an investment. Its calculation is complex, and is only recommended for businesses that are more advanced in their finances.
Many entrepreneurs evaluate their investments based on a simple profit/investment ratio. While this calculation can be useful, it is insufficient for two reasons:
Sometimes money is projected to come in different amounts. For example, you might project that in year one you will receive $1,000, in year two you will receive $500, and in year three you will receive $1,000. A formula is needed to accommodate these different amounts of profit projected into the future.
Money is not worth the same over time. For example, what would you prefer? To receive $1,000 pesos now or $1,000 pesos in three years? The IRR recognizes that money received earlier is worth more than money received later.
Don't be scared by the formula below! Later you will learn how to calculate everything in three simple steps.
Where,
F t are the cash flows at time t
n is the number of periods
Example
Suppose we are offered an investment project in which we have to invest $5,000,000 and we are promised that after that investment we will receive $1,000,000 the first year, $2,000,000 the second year, $1,500,000 the third year and $3,000,000 the fourth year.
Example
In the formula, it would look like this:
Solving the IRR by hand is impossible. Even a normal calculator philippines business mailing list cannot do it! For this you need a special calculator called a financial calculator, or Excel. Entrepreneurs who are more advanced in Excel will be able to calculate it in the following way:
Step 1: Include the flows in a row.
Step 2: Establish the “IRR” formula and select the flows.
Step 3: Enter, and it will give you the IRR of this project. In this case, it is 21% .
This IRR can be compared to a financing interest rate, for example the APR of a loan. If the APR of a loan is less than 21% (for example an APR of 10%), then it is worth financing the project with the loan and you will end up with a profit. On the other hand, if the interest rate of the loan is 25%, then it is not worth executing this project with the loan, because you would pay more in interest than you would earn from the business.