Internal Rate of Interest comes into play whenever there are cash outflows and with positve or negative inflows - something like a investment in a project or an investment with uncertain returns.
1.Present Value :To understand IRR, one should know the concept of Present Value(PV) - which is nothing but the Future Value (FV) discounted with appropriate rate of interest. For example the PV of Rs.110 to be received exactly after one year would be = Rs.100, if the rate of interest/ discount rate is 10%.
Mathematically, PV = FV/(1+r)^n ( where r is rate of interest which is 10% in this case and n is the time period, which is 1 in this case
So PV = 110/(1+10%) = 110/1.1 = 100
2. Net Present Value: When there are cash outflow which is represented by ( - ) and Cash inflows which could be either positive or negative which are spead over a period of time one can assess the net effect of all the cash flows known as Net Present Value (NPV)
NPV = CFo +CF1/(1+r)+ CF2/(1+r)^2 ………….. CFn/(1+r)^n where r is the rate of interest and n is period in question.
When calculating the NPV you will first determine the rate of interest which could be your expected rate of return or cost of capital. Assuming your cost of capital is 8%, you will use the rate of interest of 8% in the formula to ascertain the NPV. If the NPV is positive, you will make money and if Negative you will not be making money in the project.
3. Internal Rate of Return (IRR) : IRR is an interesting extension to NPV. IRR is that rate of interest that would make the NPV=0 , or at what rate of interest the project would break-even.
0= CFo +CF1/(1+r)+ CF2/(1+r)^2 ………….. CFn/(1+r)^n where n is period in question and r is the Internal rate of return ( IRR )
IRR is calculated mathematically using the above formula under trial and error with approximations.
Alternatively, you can use the Excel (Financial Formulae) which includes the calculation of IRR
