Gain a deeper understanding of the Internal Rate of Return (IRR), a crucial metric in financial analysis for determining the profitability of potential investments, explained through a practical example of a company investing in efficiency software.
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments.
IRR is calculated using the same concept as net present value (NPV), except it sets the NPV equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake.
In our example, the company purchases an important software for $45,000. That software saves money to the company in the next 5 years as it increases efficiency of the processes. Let’s see what the IRR would be for the company in this case scenario.
Please make sure that your investment of $45,000 is negative – it’s cash outflow. The money saved are cash inflows, therefore they are positive.
E28 = IRR(F21:F26)
IRR for that project is 23%, meaning it’s totally worth it to invest into the software to save money in the future.