Internal Rate of Return: When and Where to Use the Indicator

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What are we talking about? Internal rate of return is an indicator that allows you to evaluate the feasibility of investing in a new project in the long term. For this, the discounted cash flow approach is used.

How to apply? The indicator is calculated using a formula that includes the values ​​of cash flow, net present value, discount rate, and weighted average cost of capital. The calculation is performed manually using Excel and Google Sheets.



In this article:

History of the creation of the internal rate of return indicator
What is Internal Rate of Return
When is Internal peru email list Rate of Return Used?
The difference between internal rate of return and other financial ratios
Formula for calculating the internal rate of return
Calculating Internal Rate of Return in Excel and Google Sheets
The key rule for using the internal rate of return indicator
What is considered a good internal rate of return on investment?
Disadvantages and limitations of the internal rate of return method
Frequently Asked Questions About Internal Rate of Return

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History of the creation of the internal rate of return indicator
Since the late 19th century, many people have been developing methods for applying discounted cash flows. Important contributions to this area were made by Eugen von Böhm-Bawerk and Irving Fisher. In his work entitled The Theory of Interest, Fisher proposed a formula for calculating the internal rate of return (IRR), although he did not use the term himself, considering it in the context of comparing two investment projects.

The term "internal rate of return" was first expounded in detail by Kenneth Boulding in his paper "The Theory of a Single Investment" (Boulding, KE "The Theory of a Single Investment." The Quarterly Journal of Economics 49, no. 3 (May 1, 1935): 475-94).

History of the creation of the internal rate of return indicator

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That same year, John Keynes mentioned this indicator in his work “The General Theory of Employment, Interest and Money”, describing it as the marginal efficiency of capital. This work had a significant impact on the development of economic theory and became the basis for references to the IRR method.

Over the next 20 years, IRR was used to analyze investment projects, although the term did not become widely used. In some publications, it was replaced by the term yield, which continues to be used in bond analysis. The familiar expression yield to maturity is actually the IRR calculated for bonds.

Since the 1960s, the term IRR has become established as the main one, displacing other names, which contributed to the formation of the modern understanding of this financial indicator.

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What is Internal Rate of Return
Let's say you intend to invest in a startup that you expect to make a profit from in the future. To estimate the profit, you need to subtract the initial investment from the expected income.

At first glance, everything looks quite simple, but do not forget about one important point: 2000 rubles now and 2000 rubles in a year are not an equivalent amount, since money loses its value over time. Therefore, to analyze the potential income from investments in financial calculations, you need to use the discount rate.

The discount rate is a percentage value that shows the relationship between expected future income and its current value. When calculating this indicator, potential risks of a business project are taken into account: the inflation rate, political situation, management errors and other factors. The higher the risk level, the higher the interest rate at which investments can lose their value over time.

There is no universal formula for calculating the discount rate, since there is no single list of risks. Usually, the percentage associated with risk-free investments (approximately 5-6%) is taken as a basis, then the inflation rate and certain risks associated with a specific project are added to this figure.