🎯capital budgeting

Internal Rate of Return

0 = Σ CF_t / (1+IRR)^t - Initial Cost

The discount rate that makes NPV exactly zero. IRR tells you the project's implied percentage return.

Variables

IRR=Internal Rate of Return

Rate where NPV = 0

CF_t=Cash Flow

Cash flow in period t

Example Calculation

Scenario

Invest $1,000 now, receive $600 in year 1 and $600 in year 2.

Given Data

Cost:$1,000
CF1:$600
CF2:$600

Calculation

Solve: 0 = -1000 + 600/(1+IRR) + 600/(1+IRR)^2. Trial and error or calculator gives IRR ≈ 13.07%

Result

13.07%

Interpretation

The project earns 13.07%. Accept if this exceeds the hurdle rate.

When to Use This Formula

  • Quick percentage return comparison
  • Supplement to NPV analysis
  • Communicating returns to non-finance stakeholders

Common Mistakes

  • Relying on IRR alone for mutually exclusive projects
  • Ignoring multiple IRR problem with non-conventional cash flows

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FAQs

Common questions about this formula

They can disagree for mutually exclusive projects or when cash flow patterns differ. Always defer to NPV.

Yes. When cash flows change sign more than once (e.g., initial outflow, then inflows, then another outflow), the IRR equation can have multiple solutions. In these cases, use NPV or MIRR instead.

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