How to Calculate Internal Rate of Return (IRR)
Knowing how to calculate internal rate of return (IRR) can benefit both investors and business people as it provides a measure of investment performance expressed as an annual return. By definition, the IRR is the annualized rate of return that brings the net present value of a future payment stream to zero. The IRR measure provides a means of evaluating multiple investment options and, while it is used most often in the world of corporate finance, individuals can use it when evaluating various personal financial opportunities.
The Use of IRR in Personal Finance
When making personal financial and investment decisions, the IRR measure provides for the comparison of investment returns. When tracking portfolio performance, the internal rate of return can be particularly useful as it computes an annualized rate of return as it considers both the amount of money invested and the timeline for the investment. The IRR offers an indication as to how quickly you will realize returns. When evaluating investment products like certificates of deposit (CDs) or savings bank accounts, the IRR is referred to as the annualized percentage yield (APY).
The Mathematics of the Internal Rate of Return
In mathematical terms, the IRR represents the interest rate or the “discount rate” that brings the present value of a series of future cash flows to zero. The IRR is useful when there is a need to analyze a number of equal investments that occur over regular intervals or for the returns on any series of investments. When evaluating a complex series of cash flow streams (both inbound and outbound) it is often helpful to look at these activities in what is known as a “cash flow diagram”, which simply represents these activities on a timeline. Cash out is shown as negative and cash in is shown as positive. The calculator below provides a simple, but useful, tool for this.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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