Formula for Internal Rate of Return

Internal Rate of Return or IRR can be defined as the interest or the returns one gets on the investment. The mathematical formula, in general can be defined as the systematic method of reaching the inference of a problem. The formula for calculating internal rate of return 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 above stated formula is the most popularly used one to calculate the internal rate of return for calculating an approximation of return on an investment in a project. The use of the formula is mainly employed in cases where the cost of capital is less than the internal rate of return or where the hurdle cost is less than the internal rate of return. The Internal rate of return approach is beneficial if there is an interim cash flow also which in turn could be reinvested at the actual IRR.

A major drawback of using the internal rate of return method is that the investors tend to focus on maximizing the internal rate of return instead of both net present value and internal rate of return. Ignoring net present value at the cost of increasing the IRR can prove costly in the long run. It is advisable for the investors to invest in the project with a positive net present value and consider the internal rate of return as the modified rate of return and also keeping a close tab on the interim cashflows for reinvesting them back into more lucrative assignments. The primary aim of the investor should be to maximize the net present value and not to maximize internal rate of return. The Internal Rate of Return is calculated in percentages and not in hard numbers in currency form as is the case in the calculation of net present value. 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.

Both methods of approximation of maximum returns on investment are good especially in calculating the viability of the investment but it should be understood that these are at best termed as calculated risk approximation and not as risk calculation methods. The internal rate of return is a part of the net present value calculation as it denotes the discount rate when there are a number of cashflows imbibed in the calculation spread over the span of the time of investment in a project. Hence the internal rate of return makes the discount rate of the cash flows for net present value, equivalent to zero. The internal rate of return method is nevertheless a popular method among managers for calculating the returns on investment.