Internal Rate of Return Method: Definition & Calculation

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  • 0:03 Internal Rate of Return Method
  • 1:00 Understanding NPV
  • 1:57 Understanding IRR
  • 3:25 IRR with Multiple Cash Flows
  • 5:54 Making a Decision
  • 6:30 Lesson Summary
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Lesson Transcript
Instructor: Angie Tucker

Angie has trained corporate users in the fundamentals of accounting software and has a master's degree in business management.

Financial management involves determining which long-term investments are right for a company. There are several techniques used by management to analyze potential investments and determine their worthiness. One technique is the internal rate of return method.

Internal Rate of Return Method

It's the responsibility of management to determine if a specific investment will increase the stock value in a company before undertaking the costs of the investment. In other words, will this investment create value? The answer is typically yes if the investment's worth more in the marketplace than the cost to acquire it, and the internal rate of return method is one technique used by management to determine if an investment will create value.

Using the internal rate of return method, an investment which creates value is only acceptable if the internal rate of return exceeds the company's required return. The internal rate of return, or IRR is simply the rate of return required by the business (also known as the discount rate) that makes the net present value of an investment equal zero. The net present value, or NPV is the difference between the investment's market value and its cost.

Understanding NPV

Now, to better understand this concept, let's first look more closely at net present value. Financial managers at Sam's Snacks are considering an investment in new snack stands. Let's calculate the NPV when the following factors are known:

Cost to purchase the investment today = $50,000
Market value of the investment in one year = $55,000

Now let's plug these numbers into the equation for net present value:

NPV = Market value - Cost

NPV = $55,000 - $50,000

NPV = $5,000

Using this net present value approach, the managers will create $5,000 in value for the company if they move forward with the investment. Thus, the investment seems to be a good idea, and they move forward with the purchase. This is one approach to deciding if an investment is a good idea.

Understanding IRR

Now, let's apply an alternative approach, the internal rate of return method to determine if the investment is acceptable. As we discussed, the IRR on an investment is the company-required return rate that makes the NPV equal to zero. Here, we'll use the same information as the previous example but with an unknown company-required return rate, which is represented as R.

Since R is unknown, we'll use this calculation to determine the break-even company return rate. This is the point where value is neither added nor destroyed. To start, we set the NPV equal to 0 and solve for the break-even company rate of return. So:

NPV = 0 = -$50,000 + $55,000 / (1 + R)

$50,000 = $55,000 / (1 + R)

1 + R = $55,000 / $50,000

1 + R = 1.10

R = .10 or 10%

So, when the company-required return rate is 10% the NPV is equal to zero. Thus the IRR is 10%.

This tells the managers at Sam's Snacks to accept this investment if their company-required return rate is less than 10%. In other words, they should accept potential investments if the IRR for the investments exceed the company-required return rate.

IRR with Multiple Cash Flows

The IRR calculation becomes slightly more complicated when there are multiple cash flows. For example, the managers are considering an investment with a cost of $2000, cash returns in the first year of $1220, and cash returns in the second year of $1220.

To start, we set the NPV equal to 0 and solve for the break-even company rate of return:

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