Calculating Internal Rate of Return

Internal Rate of Return or IRR can be defined as the interest or the returns one gets on an investment of money in any investment that they might be considering. The internal rate of return is apparent and easy to calculate in the case of banks and financial institutions where less costs will be involved and risk factors are almost zero in most cases. The calculation for a big project with a company involves more complicated factors for consideration. It involves the roping in of more factors and variables which might influence the outcome of the returns on an investment, either directly or indirectly. The factors, when assigned numeric values and replaced in the following formula, give a meaningful result which is considered as the value of internal rate of return. The formula used for the calculation of internal rate of interest is as follows:

V = -R (1+i) ^n - [R (1+i) {(1+i) ^n - 1}/ i]

Where "V" stands for expected future value of the investment, "R" stands for present value of the investment, "n" stands for the time period the investment is to be made, and "i" stands for rate of interest for the designated period "n", "^" denotes exponential figure.

The result thus infrenced give the value in percentages and not in the currency values. The startling drawback of this method is the absence and ignorance towards the miscellaneous costs that should effect the calculation. On a conceptual level, the calculation of internal rate of return takes into account mainly the investment that is tied up in the project. Though the formula and the subsequent calculation point towards the near approximation and not the actual returns, this anomaly is not considered a major risk. The internal rate of return forms a basic part of the net present value (NPV) calculation. The internal rate of return replaces the multiple cash flows over a time period into discount rate and thus enabling a smoother calculation of the net present value. The discount rate is thus equal to zero for a close approximation of net present value of the investment in a project. The Internal Rate of Return is calculated in percentages as compared to the net present value which is calculated in currency dominations. This aspect makes Internal Rate of Return a more popular method for evaluation of investment for the investors as compared to net present value though net present value is more accurate.

The internal rate of return is a method mostly used by managers and individuals for investing in projects. The easy and clear calculation lures the investors into making the internal rate of return method the basis for an investment. This could lead to mistakes as the long term benefits should be considered and a higher net present value should be the criteria and not the higher internal rate of return. The loophole for this method is the overindulgence of the calculation on the macro factors and not on the intricate factors. This method is good for calculating the investment in the small projects with limited liability.