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Example of Calculating IRR
Example of Calculating IRR
Example of Calculating IRR
It might be easier to look at an example than to keep explaining it. Let’s look
at Tom’s Machine Shop. Tom is considering purchasing a new machine, but
he is unsure if it’s the best use of company funds at this point in time. With the
new $100,000 machine, Tom will be able to take on a new order that will pay
$20,000, $30,000, $40,000, and $40,000 in revenue.
Let’s calculate Tom’s minimum rate. Since it’s difficult to isolate the discount
rate unless you use an excel IRR calculator. You can start with an
approximate rate and adjust from there. Let’s start with 8 percent.
As you can see, our ending NPV is not equal to zero. Since it’s a positive
number, we need to increase the estimated internal rate. Let’s increase it to
10 percent and recalculate.
As you can see, Tom’s internal return rate on this project is 10 percent. He
can compare this to other investing opportunities to see if it makes sense to
spend $100,000 on this piece of equipment or investment the money in
another venture.
Going back to our machine shop example, assume Tom could purchase three
different pieces of machinery. Each would be used for a slightly different job
that brought in slightly different amounts of cash flow. Tom can calculate the
internal rate of return on each machine and compare them all. The one with
the highest IRR would be the best investment.
Since this is an investment calculation, the concept can also be applied to any
other investment. For instance, Tom can compare the return rates of investing
the company’s money in the stock market or new equipment. Now obviously
the expected future cash flows aren’t always equal to the actual cash received
in the future, but this represents a starting point for management to base their
purchase and investment decisions on.
Meanwhile, another similar investment option can generate a 10% return. This
is higher than the company’s current hurdle rate of 8%. The goal is to make
sure the company is making better use of its cash.
To make a decision, the IRR for investing in the new equipment is calculated
below.
Excel was used to calculate the IRR of 13%, using the function, =IRR(). From a
financial standpoint, the company should make the purchase, because the IRR
is both greater than the hurdle rate and the IRR for the alternative investment.
What is Internal Rate of Return Used For?
Companies take on various projects to increase their revenues or cut down
costs. A great new business idea may require, for example, investing in the
development of a new product.