IRR Internal Rate of Return Explained in 3 Easy Steps: How to Calculate Internal Rate of Return


Uploaded by MBAbullshitDotCom on 27.02.2010

Transcript:
IRR Internal Rate of Return Explained in 3 Easy Steps:
How to Calculate Internal Rate of Return Hello and welcome once again to MBABULLSHIT.COM.
Our topic for this video is the Internal Rate of Return, also known as the IRR. I know it
looks a bit scary, but it’s really just bullshit. I will show you how it’s very
easy. Remember that you can always come back to MBABULLSHIT.COM.
Before you watch this video, I highly recommend (it’s not a requirement) that you first
know future, present value, and net value before you watch this video. Before you learn
IRR, you should first understand the simple “rate of return”. This refers to the speed
that money comes back to you after you invest it. Let’s say you give / put money in a
business or deposit in a bank, and you get back profit. How fast does your money come
back to you after you’ve invested / deposited it? More on that later.
This rate of return is written as a percentage per year, also know as P.A. or per annum. As an example, let’s say that
you invest $100 today and then you get back $3 every year forever. In this case, we can say that the rate of return is 3% per
year. Why is it 3%? Because $3 is exactly 3% of $100 and you’re getting it per year
or per annum. In this case, the rate of return is 3% per annum. You see, it’s very simple.
You don’t even need a formula in this case. You can easily estimate that earning $3 per
year forever after a $100 investment equals 3% per year rate of return.
Now we ask ourselves, what if the situation is not that easy and simple? For example,
what if you invest $100 today and you get back $60 after 1 year, and you get back another
$60 after 2 years, and then the money you get stops unlike in the past example where
you get money forever. In this case, how do we compute the rate of return? In this case,
the rate of return is hidden. This means it’s not easy to see the rate of return. In MBABULLSHIT
language, another word
for “hidden” is “internal”. The word “hidden” doesn’t sound so beautiful.
So now we call it the “internal rate of return” or IRR. In order to get the Internal Rate of Return,
we need to use a formula. Before we go to the formula, I want you to think about the
future cash outflow and the future cash inflow. The future cash outflow was $100 that you’re
investing. The inflow is $60 that you get, and another $60. Think about the outflow and
inflow. Then think about the value today using the
present value formula. It will look something like this:
Do you remember this? This is very similar to the present value formula. First, which
here is the cash outflow and which is the cash inflow? The cash outflow is the $100
investment and you would notice that it is negative $100. Why is it negative? Because
you are investing it or you are paying it. When you invest money, you take money away
from yourself to put in a bank or in a business. In a way, you are losing money, maybe temporarily,
but you are losing money… that’s why it is negative.
For the cash inflow, it is $60 for the first year and another $60 for the second year.
It is positive because it increases the money you have and you get the money bank.
Next, we still don’t know the “r” or the rate of return here because that’s what
we’re trying to find out. We want to find out what “r” is over here.