Internal Rate Of Return (IRR) can be thought of as the annualized growth rate that makes all the cash flows (both positive and negative) of an investment come out to zero. It’s like a magic discount rate that balances out all the ups and downs of your investment to tell you a single percentage that reflects its overall profitability. By calculating the IRR, you can find a single rate that considers the time value of money for all these cash flows and tells you the overall return on your investment.
IRR is called internal because it depends only on the cash flows of the investment being analyzed and excludes external factors, such as returns available elsewhere, the risk-free rate, inflation, the cost of capital, or financial risk. The IRR of an investment is the interest rate that gives it a net present value of 0, or where the sum of discounted cash flow is equal to the investment.
IRR is calculated by trial and error as a solution of this equation:
where: N = total number of periods, = time period, = cash flow at period .
Lets take same example: invest $10,000 in a project that gives you $2,000 in year 1, $3,000 in year 2, and $8,000 in
year 3. IRR for this project is 11.397637%. Indeed, in Table 2.3 such IRR balances sum of PVs to zero. Solutions to
equations like this are better to do in spreadsheets, and both Excel and Google Sheets provide IRR function for
simplicity. For this example that would be =IRR({-10000,2000,3000,8000}).
IRR is useful to compare different investment options with varying cash flow patterns based on a single metric. A higher IRR generally indicates a more desirable investment. Keep in mind, IRR doesn’t consider risk. A riskier investment might have a higher IRR than a safer one, but you need to weigh the potential return against the risk involved. IRR doesn’t account for reinvesting your returns, which can affect your overall growth.