The internal rate of return (IRR) measures the average annual rate of return an investment generates based on its initial cost and its cash flows over the holding period of the investment. You can calculate an investment's IRR if it generates only a single cash flow at the end of a particular year. An example of an investment with an initial outlay and a single cash flow is a bond that pays no periodic interest payments and pays only the face value at the bond's maturity. You can calculate an investment's IRR to determine its potential returns.
1. Determine the initial cash outlay of an investment, the single cash flow and the year in which the investment generates the cash flow. For example, assume an investment has an initial outlay of $750 and produces a single cash flow of $1,000 at the end of the fifth year.
2. Substitute the values into the IRR formula for a single cash flow: IRR = [(single cash flow/initial outlay)^(1/year of cash flow)] - 1. In this example, substitute the values to get: IRR = [($1,000/$750)^(1/5)] - 1.
3. Divide the single cash flow by the initial outlay. In this example, divide $1,000 by $750 to get 1.33. This leaves: IRR = [1.33^(1/5)] - 1.
4. Divide 1 by the year of the single cash flow. In this example, divide 1 by 5 to get 0.2. This leaves: IRR = (1.33^0.2) - 1.
5. Raise the number in parentheses to the power of the exponent. In this example, raise 1.33 to the power of 0.2 to get 1.059. This leaves: IRR = 1.059 - 1.
6. Subtract 1 from your result to calculate the investment's IRR. Then multiply your result by 100 to convert it to a percentage. In this example, subtract 1 from 1.059 to get 0.059. Then multiply 0.059 by 100 to get an IRR of 5.9 percent. This means the investment generates an average annual rate of return of 5.9 percent.
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