1. Internal Rate of Return
In the previous lesson, our initial investment of $1000
generating an annual cash flow of $400 for three years and using a
discount rate of 5% had a positive NPV of 89.30. Because the NPV
is positive, the actual return that we are receiving is greater than 5%.
As the required return or discount rate increases the NPV falls,
in other words, to get a high return, pay less for the investment
today. For example, if the discount rate increases to 12%,
the NPV falls to 39.27. So the return that we are actually getting
is less than 12%. So using some simple logic, somewhere between 5%
and 12%, the NPV must be zero. The discount rate or the return
that gives an NPV of exactly zero has a special name,
the Internal Rate of Return or IRR. This is the return,
the investment or project is actually delivering to investors or companies,
and by considering the IRR and whether the NPV is positive or negative,
investors and companies can make more informed decisions about whether to
proceed with an investment or project or not.
Sometimes calculating the IRR can be a process of trail and error, but
luckily, Excel has a function called IRR to make the calculation easy.
Using the IRR format in Excel is fairly straightforward. We start by typing
IRR and open the brackets, and we start with our initial investment this
time and then include the future values. Now, there is a second optional
input for the IRR function, which is in square brackets there,
that's how we know it's an optional input and it's a guess.
So if you knew roughly what the IRR is you could put it
in but you don't really have to and so I'm going to leave
it out. And so here, this particular investment has an internal rate of
return of 9.7%.
2. Let's practice!