Internal Rate of Return (IRR) Method

An internal rate of return is the discounting rate, which brings discounted future cash flow at par with the initial investment. In other words, it is the discounting rate at which the company will neither make loss nor make a profit.

The Internal Rate of Return (IRR) is a financial metric used to calculate the rate at which an investment breaks even, or in other words, the rate at which the net present value (NPV) of an investment becomes zero. The IRR is essentially the discount rate at which the sum of all future cash flows from an investment is equal to the initial investment amount.

To calculate the IRR, you need to know the initial investment amount, as well as the expected cash flows from the investment over its life. These cash flows can be positive or negative and should be discounted to their present values using a discount rate. The IRR is the discount rate that makes the net present value of these cash flows equal to zero.

The IRR is often used in financial analysis to compare the profitability of different investments. Generally, a higher IRR is better, as it indicates a higher rate of return on the investment. However, it is important to note that IRR has some limitations, including assumptions about the reinvestment of cash flows and the timing of those cash flows. Therefore, it should be used in conjunction with other financial metrics to make informed investment decisions.

It is obtained by trial & error method. We can also state that IRR is the rate at which the NPV of the project will be zero. i.e. Present value of cash inflow – Present value of cash outflow = zero

where:

C_t​=Net cash inflow during the period t

C₀​=Total initial investment costs

IRR=The internal rate of return

t=The number of time periods​

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