Internal rate of return (IRR) computes the rate at which the investment pays for itself. This can be compared against a desired rate of return. If the IRR is greater than a desired rate, the investment may be attractive. The internal rate of return method does not take interest per year or periods per year into consideration when calculating.
The internal rate of return calculation is very complicated. Calculating IRR uses an iterative approach to solving the problem and, if there is an answer, may take quite some time to calculate. A few caveats to calculating internal rate of return exist. First, long calculations may be interrupted because an iterative limit is exceeded within the calculator itself. Errors may occur in other areas as well. If there is no sign change within the cash flow problem, an error will occur. If the cash flow will yield a negative IRR amount, an error will occur. A negative IRR means that there is at least one negative answer and possibly multiple negative and positive answers to the same cash flow question. In these situations, the calculator will not display an answer. Finally, if there are multiple sign changes (two or more) within the same problem, there may be multiple solutions. Note that multiple sign changes may not give an answer for IRR. Also, if IRR is less than zero it does not give an answer on IRR. The calculator gives the IRR closest to 0, but extreme caution should be used in basing an investment on this type of cash flow. See the Understanding Cash Flows section for more information.
Another method for solving IRR problems is by estimating an interest per year value and calculating net present value (NPV). Internal rate of return is calculated by solving for NPV when it is equal to 0. With this in mind, by estimating an interest per year amount, you can solve for the internal rate of return. The closer to a net present value of zero, the more accurate the IRR estimate becomes.
