What does IRR mean? How to calculate?

Internal rate of return (IRR) can be regarded as the average return that investors can get during the duration of the project. It refers to the discount rate of an investment at the economic break-even point, which is an important substitute for the net present value method.

How to understand IRR?

The meaning of IRR is the same as IRR, which refers to discounting the future annual net cash flow of the investment scheme, so that the obtained present value is exactly equal to the present value of the original investment, so that the net present value is equal to the discount rate of zero.

The basic principle of IRR method is: when calculating the net present value of the scheme, the expected return on investment is used as the discount rate, and the result of NPV is often greater than or less than zero, which means that the actual possible return on investment of the scheme is greater than or less than the expected return on investment; When the net present value is zero, the two yields are equal. According to this principle, IRR method is to calculate the discount rate that makes the net present value equal to zero, and this discount rate is the actual possible return on investment of the investment scheme.

How to calculate internal rate of return?

The calculation steps of internal rate of return can be calculated according to the following steps:

Step 1: Calculate the present value coefficient of annuity. Annuity present value coefficient = initial investment/annual net cash flow.

Step 2: Calculate two discount rates (a% and b%) which are close to the present value coefficient of annuity mentioned above.

Step 3: According to the above two adjacent discount rates and the present value coefficient of annuity, the internal rate of return of investment scheme is calculated by interpolation method.

What is the difference between IRR and profit index?

Profit index method:

Profit index is the ratio of the sum of the present value of future net cash inflows discounted at a certain cost of capital to the original investment.

Decision criteria: profit index ≥ 1, feasible scheme and profit index.

1, the scheme is not feasible.

Advantages: It is basically the same as the net present value method, but the difference is that the profit index is a relative number, which can reflect the relationship between capital input and output of project investment from a dynamic perspective, and can make up for the defect that the net present value cannot be compared between different investment schemes.

Disadvantages: it cannot directly reflect the actual rate of return of investment projects, and the calculation is more complicated than the net present value index, and the calculation caliber is also inconsistent.

Internal rate of return method:

Internal rate of return refers to the discount rate that the present value of expected cash inflow of investment projects is equal to the present value of cash outflow.

Decision criteria: IRR ≥ discount rate, feasible scheme, IRR.

Discount rate, the scheme is not feasible.

Advantages: pay attention to the time value of funds; Directly reflect the actual income level of investment projects from a dynamic perspective; The influence of not loving the industry benchmark rate of return is more objective.

Disadvantages: calculation trouble; When a large amount of additional investment is made during the operation period, it may lead to the emergence of multiple IRR, which has no practical significance.