Prize: Free (and early) access to a new online course that we have under development and an F1F9 mug.
Thanks again to all who took part in Modelling Challenge #4 on NPV. I think it yielded some fascinating results.
This week we move on to the twin brother of NPV – The Internal Rate of Return or IRR.
Internal Rate of Return (IRR) is a key metric used by investors to calculate the attractiveness of a potential investment. Investopedia defines IRR as follows:
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
You can estimate an IRR by using the NPV formula as a starting point.
Ct = net cash inflow during the period t
Co= total initial investment costs
r = discount rate, and
t = number of time periods
To calculate IRR using the formula, set the NPV equal to zero and solve for the discount rate r, which is the IRR.
While investors routinely use IRR as a key metric in decision-making, I have a sneaking suspicion that it is a minority of investors who could accurately describe how to calculate the IRR of a project.
The challenge is simple – calculate the annual IRR of the future pre-tax, pre-financing cash flows of the project.
- 1. Download the template model from here (or above)
- 2. Based on the cash flows in the model, found on the Cashflow sheet, calculate the IRR using the guidelines above.
- 3. If you are brave enough, post your answer (the calculated IRR). Otherwise, you can e-mail me your answer and calculations email@example.com
- 4. We will select the winner using our complex Excel-based randomiser
- 5. We’ll also post the answer in a couple of weeks.