Overview and Formula
- The IRR is calculated by using an NPV equal to zero. It is initially subtracted from the investment value. Each year's ensuing cash flow is divided by one plus the IRR to the power of the year since the investment. Then the values are added together to equal zero. While it is a little complicated, the formula appears as follows: 0 = - Value of Investment + (Cash Flow Year 1)/(1 + IRR)^1 + (Cash Flow Year 2)/(1+ IRR)^2.
- A standard personal project might be an addition to a home or swimming pool. Your analysis would tell you how much you could spend so the value of the addition does not affect the overall value you receive from the home when sold. Since you most likely do not receive any cash flow on the home, all of the value would be earned in the final year. The IRR would be based on the increased value of the home per year based on the addition. Assuming you plan on selling the home in four years, 0 = - (cost of renovation) + (increased value of your home/(1 + IRR)^4.
- Government projects can also create an IRR analysis. They are a little tricky to calculate exactly because it is hard to divorce what the base growth rate of a state or country would have been without the project. However, a more accurate analysis can be done on revenue-generating projects such as toll roads. In this case, the cost of building the road would be compared to the projected cash flow over time.
- Businesses are the most frequent users of IRR analysis due to constant investor pressure to maximize returns. A business uses IRR to determine how they have been performing in the past and also to set expectations for the future. When considering new projects, if they are not projected to exceed the current IRR then they should be rejected as a poor investment choice. In other words, they do not exceed the choice of doing no new investment at all. Examples of IRR projects include new machines, new production facilities or marketing campaigns.