The Net Internal Rate of Return (Net IRR)

Time to put your business top hat on, like Rich Uncle Pennybags (the monopoly guy). Sometimes, business get to the point where they ponder about investing or buying something big. Maybe they want to open a new branch, an additional factory, or buy some new equipment. But would it be worth it? How long would it take to pay off such a big purchase? This is called “capital budgeting.”

The net internal rate of return helps businesses estimate the potential profitability of such investments. It sets the net present value (NPV) of all cash flows from the project equal to zero.

The NPV calculation has two parts.

First, it takes the net cash flow during a period of time, and divides it by one plus a discount rate over the same period of time. This is known as a discount rate. It’s kind of the reverse of calculating compound interest, where you ask yourself, If I invest x amount today, how much will it be worth in y years based on z interest gained? The discount rate asks the opposite, which is, How much will x amount of money be worth in y years based on z interest lost?

Second is the total investment costs of the project.

So subtract the second part (costs) from the first part (estimated money you’d make over a time period, discounted for changes in interest rates and inflation), and you get NPV. Setting NPV to zero gives you the net internal rate of return. When NPV is zero, that means you can at least break even, making the investment worth it. Thus, you learn how much you’d need to make over time to make a big investment worth it.