Answers the Question
Is this a good use of my money?
Calculator for Internal Rate of Return
What Is the Internal Rate of Return?
Internal rate of return goes by many alternate names including:
- Discounted cash flow rate of return
- Economic rate of return
No matter what you call it, it is most often used for measuring the profitability of a given investment over time. It is essentially a ratio of income received from an investment.
Why Is it Important?
- It's not always clear where money should be invested. The internal rate of return formula highlights the value of each potential investment so that the optional one can be selected.
Formula(s) to Calculate Internal Rate of Return
- INITIAL COST = SUMMATION OF ( INCOME FOR YEAR X / ((1+IRR)^X )
- Not realizing that investments in capital expenditures (such as cars, factories, and intellectual property) can be sold for additional return.
- Considering return in isolation. Even an investment that has an excellent return may be overshadowed by better options.
- Not considering risk. As the saying goes, the bigger the risk, the bigger the potential for profit. Sophisticated models will often try to modify the model to account for potential risk.
- Forgetting that this formula explicitly avoids any thought of interest rates, inflation, and many other financial costs.
- Comparing the IRR of investments with different time horizons is often a complicated matter that requires more complicated financial models.