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The Internal Rate of Return is the interest rate that makes the Net Present Value zero.
It is an Interest Rate.
You find it by first guessing what it might be (say 10%), then work out the Net Present Value (I will show you
how).
Then keep guessing (maybe 8%? 9%?) and calculating until you get a Net Present Value of zero.
So the key to the whole thing is ... the Net Present Value!
An investment has money going out (invested or spent), and money coming in (profits, dividends
etc). You hope more comes in than goes out, and you make a profit!
But before adding it all up you should calculate the time value of money.
Example: Let us say you can get 10% interest on your money.
So $1,000 now could earn $1,000 x 10% = $100 in a year.
Your $1,000 now would become $1,100 in a year's time.
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Present Value
So $1,100 next year is the same as $1,000 now (at 10% interest).
PV = FV / (1+r)n
PV is Present Value
FV is Future Value
r is the interest rate (as a decimal, so 0.10, not 10%)
n is the number of years
And let's use the formula:
Example: Alex promises you $900 in 3 years, what is the Present Value (using a 10%
interest rate)?
The Future Value (FV) is $900,
The interest rate (r) is 10%, which is 0.10 as a decimal, and
The number of years (n) is 3.
Use the formula to calculate Present Value of $900 in 3 years:
PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).
PV = FV / (1+r)n
PV = $900 / (1 + 0.06)3 = $900 / 1.06 3 = $755.66 (to nearest cent).
Example: You invest $500 now, and get back $570 next year. Use an Interest Rate of
10% to work out the NPV.
Money Out: $500 now
Example: Same investment, but work out the NPV using an Interest Rate of 15%
Money Out: $500 now
Now it gets interesting ... what Interest Rate would make the NPV exactly zero? Let's try 14%:
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And we have discovered the Internal Rate of Return ... it is 14% for that investment.
Because 14% made the NPV zero.
Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the
3rd year.
Let us try 10% interest:
Now: PV = -$2,000
Year 1: PV = $100 / 1.10 = $90.91
Year 2: PV = $100 / 1.102 = $82.64
Year 3: PV = $100 / 1.103 = $75.13
Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29
Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97
I will take a better guess now, and try a 12% interest rate:
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Now: PV = -$2,000
Year 1: PV = $100 / 1.124 = $88.97
Year 2: PV = $100 / 1.124 2 = $79.15
Year 3: PV = $100 / 1.124 3 = $70.42
Year 3 (final payment): PV = $2,500 / 1.124 3 = $1,760.52
Adding those up gets: NPV = -$2,000 + $88.97 + $79.15 + $70.42 + $1,760.52 = -$0.94
That is good enough! Let us stop there and say the Internal Rate of Return is 12.4%
In a way it is saying "this investment would earn 12.4%" (assuming it all goes according to plan!).
Example: instead of investing $2,000 like above, you could also invest 3 yearly sums of $1,000 to gain
$4,000 in the 4th year ... should you do that instead?
I did this one in a spreadsheet, and found that 10% was pretty close:
Doing your calculations in a spreadsheet is great as you can easily change the interest rate until the NPV is zero.
You also get to see the influence of all the values, and how sensitive the results are to changes (which is called
"sensitivity analysis").
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Present Value
Net Present Value
Investment/Loan Graph
Investing (Introduction)
Money Index
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