How Does it Work?

When an investor, which might be an individual or a company, analyzes the viability of a prospective investment, such as a stock or a client project, the investor is interested in that investment’s net present value (NPV). The NPV is an arithmetic function that expresses something’s estimated future value at the present time. The internal rate of return is the rate that would, in theory, make an investment’s NPV equal to zero. This means that the IRR might be positive or negative. A negative IRR value indicates that an investment is likely to lose money and should be ruled out. A positive IRR value indicates viable future returns and should be maximized.

Net Present Value

Calculation

An investment’s internal rate of return is derived by solving the net present value equation for the rate of return, substituting zero for the NPV value itself. Similar to solving the NPV, solving for the rate of return may yield either a positive or negative IRR value. Calculated in conjunction with an investment’s specific NPV, this IRR calculation provides an estimate of the annual cash returns accounting for revenues and expenses for a specific number of years into the future.

Implications for Companies

References

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