When you want to measure the profitability of some kind of investment, one of the best things you can do is to use our Rate Of Return Calculator. All you need to do is to simply add your initial investment or cash out on Year 0 and then add for each one of the subsequent years the cash in or return on investment and the investment or cash our during that same year.
One of the main advantages of using our Rate Of Return Calculator is that you can easily add or remove the number of years by choosing, at the top, the total number of cash flows.
As you add the amounts for each year, you will see that the IRR or rate of return on your investment, keeps changing. This will also get you a better perspective on your investment.
In case you want to analyze more than one investment, all you need to do is to click on the “Reset” button. You can then add the new values for the second investment for which you can determine the rate of return.
While for many people this is an unknown metric, the truth is that it can be quite helpful. After all, you can think about the internal rate of return as an interest rate.
Simply put, the internal rate of return is a discount rate that is the result when the new preset value of the investments or cash inflows and the returns, withdrawals, or cash outflows are equal to zero.
One of the things that is also taken into consideration when you are calculating the internal rate of return on an investment is time. In fact, the earlier cash flows tend to have more weight than the later cash flows. This is due to one simple reason: the time value of money.
Knowing your internal rate of return using an IRR calculator is very important because it allows you to easily compare different investments. The reality is that even when two different investments include different number cash-in years, they can still be compared thanks to the use of the IRR.
Let’s just consider a simple example. Let’s say that you are looking at two different properties that are for sale right now. You like both but you just can’t seem to discover which one may be a better investment for you.
Both properties offer price is the same and the projected rents are the same as well. The difference between the two properties is that Property 1 needs an upfront renovation while Property 2 has higher property taxes. So, which one of the properties is a better investment for you?
The truth is that you would only need to add all the values for one property and then for the other on our IRR calculator and get the Internal Rate Of Return (IRR) for each one of them to see what’s the best investment.
As we already mentioned above, the Internal Rate of Return is the discount rate that makes the NPV (net present value) of a project zero. So, we can also say that the Internal Rate of Return of an investment is what you will gain on an investment or project. Since the net present value is always zero, we can also say that your initial investment is equal to the present value of the future cash flows of the investment or project.
When you have a company and you are trying to evaluate the Internal Rate Of Return of a specific project or investment, you will take this percentage and compare it with your company’s cost of capital.
In case the IRR is lower than your company’s cost of capital, the project or investment will be declined. On the other hand, in case the IRR is equal or greater than your company’s cost of capital, then, in this case, you will probably accept the project or investment. We are only stating the “probably” because the acceptance or decline of a project depends on multiple factors, both qualitative and quantitative, and not only on the IRR comparison with the company’s cost of capital.
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The truth is that in order to calculate the Internal Rate Of Return, you need to use the same formula that is used to calculate the NPV (net present value).
So, here is the NPV formula that is also the IRR formula:
Let’s say that you own a company and you need to decide whether you should buy or not a new equipment that costs $100,000.
According to the management, this new equipment has an expected life expectancy of 4 years and they also estimate that it can generate an additional $16,000 of annual profits. In the fifth year, your company is thinking about selling the equipment for its salvage value that is around $10,000.
At the same time, your company also has an investment option that needs to consider. This new investment can generate a return of 10% to your company and when compared with your company’s current hurdle rate, it’s greater. At this moment, your company’s current hurdle rate is at 8%.
So, which one of the best option for your company?
The first thing you need to do is to use our Rate Of Return Calculator to determine the IRR of the first investment. Then, you need to use our Rate Of Return Calculator to determine the IRR of the second investment.
When you compare both results and even if they are both equal or greater than the company’s current hurdle rate, you will choose the one that has a higher IRR.
One of the things that you need to keep in mind when you are calculating the Internal Rate Of Return of a project or an investment is that the result isn’t given in terms of real dollars, as it happens with the NPV (net present value). For example, let’s say that the only thing you know about an investment or a project is that it is 30%. Per se, this value doesn’t mean anything because you just don’t have a way to tell if you are talking about 30% of $1,000,000 or 30% of $100,000.
So, when you are making a business decision about two different investments, it’s always a good idea to use other measurements along with the Internal Rate Of Return. This is even truer when you are comparing two different projects or investments with different durations.
Let’s say that you have a company which hurdle rate is 12%. So, you now have the option of investing in Project A which has an IRR of 25% and is just a 1-year project. However, at the same time, you also have the option to invest in Project B which is a 5-year project and has an IRR of 15%.
If you were simply looking at the Internal Rate Of Return (IRR), you would immediately choose Project A because it has a better return. However, you wouldn’t be taking into consideration the duration of each project and this decision would turn out to be a bad financial decision for your company.