How can you calculate the IRR of an investment?

1 Trial and error method

The trial and error method is an easy way to estimate the IRR of an investment. This method involves guessing different interest rates and plugging them into the NPV formula until the NPV is close to zero. The NPV formula is C0 + C1/(1+r) + C2/(1+r)^2 + ... + Cn/(1+r)^n, where C0 is the initial investment, C1, C2, ..., Cn are the cash flows in each period, r is the interest rate, and n is the number of periods. To use this method, you must first choose a low and high interest rate that you think are possible for the investment. Then, calculate the NPV using these two rates. If the NPV with the low interest rate is positive and the NPV with the high interest rate is negative, then the IRR lies between them. If not, adjust your estimates and repeat the calculation. Narrow down your range by using the average of your low and high guesses as a new one. Compare it with zero and repeat this process until you find an interest rate that makes the NPV close to zero; this will be your estimated IRR.

2 Excel formula

The Excel formula is an efficient way to calculate the IRR of an investment. It utilizes the built-in function IRR which takes the cash flows as an argument and returns the IRR as a decimal. To use this formula, enter the cash flows from the investment in a row or column on Excel. Note that the initial investment should be negative and the subsequent cash flows should be positive. Then, select an empty cell where you want to display the IRR and type =IRR(values), where values is the range of cells with the cash flows. After pressing enter, you will receive the IRR as a decimal. To show it as a percentage, click on the % icon on the Home tab.

3 Benefits and limitations of IRR

The IRR is a useful metric for comparing different investments and choosing the best one. It shows the return that you can expect from an investment without considering external factors such as inflation, taxes, or opportunity cost. It also helps you to evaluate the feasibility of an investment by comparing it with your required rate of return or the cost of capital. If the IRR is higher than your required rate of return, then the investment is worth pursuing. If the IRR is lower, then the investment is not profitable.

However, the IRR also has some limitations that you should be aware of. First, the IRR assumes that the cash flows from the investment are reinvested at the same rate as the IRR. This may not be realistic in some cases, as the actual reinvestment rate may be higher or lower than the IRR. Second, the IRR may not exist or may not be unique for some investments that have unconventional cash flows. For example, if the investment has multiple negative and positive cash flows, there may be more than one interest rate that makes the NPV zero. This can create confusion and ambiguity when comparing different investments. Third, the IRR does not account for the size, timing, or risk of the cash flows. For example, an investment that has a large initial outlay and small cash flows later may have a higher IRR than an investment that has a small initial outlay and large cash flows later, but the latter may be more desirable in terms of NPV or payback period.

4 Here’s what else to consider

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