A Internal Rate of Return (IRR)comes from English Internal Return Rate (IRR) and is a mathematical-financial formula used to calculate the discount rate that would have a certain cash flow to equal its net present value to zero. In other words, it would be the rate of return on the investment in question.
When To Use: IRR is one of the key indicators in project return or company valuation analyzes (valuation). The most famous terms for studies of the genre are economical viability with variations and economical-financial or technical-economic.
How to calculate: In this post, we will show you how to calculate the Internal Rate of Return through Excel, but the mathematical calculation that actually occurs is as follows:
In which, F means the cash flow for each period and the t is the period in question. As we are seeing it, each cash flow will be divided by the high IRR to its respective period, since interest, in this case, is compounded. And all this must be equal to zero.
Now that we have seen the mathematical side, let's look at the practical side via Excel. To calculate the IRR, it is enough to have the free cash flow of your financial projection, we will use the same example of the Net present value:
In this case, the project had an initial investment of R $ 20.000,00 and then generated R $ 10.000,00 of profit in the following months. To calculate the IRR, in this case, simply choose the cell in which you want to see the result and choose the IRR formula (IRR) and select the cells of the desired cash flow.
In this case, we have the incredible TIR: 41,04%
How to Interpret: This means that the investment in question has a return rate of 41,04%. So you should compare it to your minimum investment attractiveness rate, which would be the minimum expected return on the contract. This is usually compared to other financial returns as investments in funds, but can also be seen in relation to the risk of the operation, ability to dispose of the business and also other opportunities.
Lastly, because it is a percentage rate, it allows you to compare the return of the most different types of investments within the same criteria!
Traps: IRR is a rate that is best suited for simpler cash flows (for example, the first negative period and positive futures). In addition, in some cases, there may be conflicts between the NPV and the IRR. When this occurs, it is suggested to follow the NPV.
Was the importance of this analysis clear? At LUZ, we offer a worksheet ready in excel for economic feasibility calculation of projects!