How to Calculate Internal Rate of Return on a Financial Calculator

The Internal Rate of Return (IRR) is a financial metric that estimates the profitability of potential investments. It represents the discount rate at which the net present value (NPV) of all cash flows from a project or investment equals zero. This calculation provides an annualized rate of return, useful for comparing different investment opportunities on a standardized basis. Learning to calculate IRR with a financial calculator is a practical skill for evaluating financial decisions.

Understanding Cash Flows for IRR Calculation

Accurately identifying and categorizing cash flows forms the foundation of any IRR calculation. Cash flows represent the movement of money into or out of a business or investment. They are broadly classified as initial investments, subsequent cash inflows, and subsequent cash outflows.

An initial investment is recorded as a negative value, representing a cash outflow. This amount includes all upfront costs to begin a project or acquire an asset, such as equipment, shipping, installation, and initial operational expenses. For example, purchasing a new machine for $10,000 would be recorded as -$10,000.

Subsequent cash inflows are positive cash flows an investment generates over time, such as revenue or cost savings. Conversely, subsequent cash outflows are negative cash flows occurring after the initial investment, like ongoing maintenance or additional capital injections. Assigning the correct positive or negative sign to each cash flow is essential, as financial calculators interpret these signs to differentiate money received from money spent. Correctly identifying and sequencing cash flows ensures accurate IRR calculation.

Preparing Your Financial Calculator for IRR Data Entry

Before inputting cash flow data, prepare your financial calculator to ensure accurate computation. This involves clearing any previously stored data in its memory and cash flow registers. Overlooking this step can lead to incorrect results due to residual values from prior calculations.

Many financial calculators use a “clear work” or “clear all” function. This resets the cash flow worksheet and other financial registers for new data entry. Some calculators also allow setting the number of decimal places for display.

Once cleared, cash flow values are entered into the calculator’s memory registers. The initial investment, CF0 (cash flow at time zero), must always be a negative value, representing money spent. Subsequent cash inflows and outflows are entered chronologically as CF1, CF2, and so on, with positive signs for inflows and negative signs for outflows. If identical cash flows occur for multiple consecutive periods, many calculators allow entering the frequency (Nj) of that cash flow, streamlining data entry.

Step-by-Step IRR Calculation

Once the financial calculator is prepared and all cash flows are correctly identified and entered, compute the Internal Rate of Return. This requires specific button presses depending on the calculator model. Remember that the calculator assumes regular time intervals between cash flows for the IRR function.

For this example, consider a project with an initial investment of -$10,000, followed by cash inflows of $3,000 in Year 1, $4,000 in Year 2, $5,000 in Year 3, and $2,000 in Year 4.

Texas Instruments BA II Plus

To calculate IRR using the Texas Instruments BA II Plus, clear any previous cash flow data. Press 2nd then CLR WORK (above the CE/C button) to clear the cash flow worksheet. Then, press the CF button to enter cash flow mode.

Input the initial investment: type 10000, press +/- to make it negative, and press ENTER. Then, press the down arrow ↓. For subsequent cash flows, input each amount followed by ENTER and ↓. For this example: 3000 ENTER ↓, 4000 ENTER ↓, 5000 ENTER ↓, and 2000 ENTER ↓.

If a cash flow repeats, after entering the amount and ENTER, press ↓ to show F0X=1, then enter the number of repetitions and ENTER before pressing ↓ again. After entering all cash flows, press the IRR button, then CPT (Compute) to display the calculated IRR.

HP 12c

Calculating IRR on the HP 12c financial calculator requires clearing its memory before data entry. Press f then CLEAR FIN (above the REG button) to clear the financial registers.

Enter the initial investment: type 10000, then press CHS (Change Sign) to make it negative. Next, press g and CF0 (above the PV button) to store it as the initial cash flow. For subsequent cash flows, input each positive or negative amount. For this example: 3000, then g and CFj (above the PMT button). Repeat for each remaining cash flow: 4000, g, CFj; 5000, g, CFj; and 2000, g, CFj.

If a cash flow repeats, after entering the value and g, CFj, type the number of repetitions and then g, Nj (above the FV button). After all cash flows are entered, press f and IRR (above the FV button) to compute the Internal Rate of Return.

Meaning of the Calculated IRR

The calculated Internal Rate of Return provides a percentage reflecting an investment’s estimated annual growth rate. This percentage represents the maximum discount rate an investment could withstand before it ceases to be profitable. A higher IRR generally indicates a more desirable investment opportunity, assuming all other factors are comparable.

Businesses and individuals use IRR as a tool in investment decision-making, often comparing it to a “hurdle rate” or cost of capital. The hurdle rate is the minimum acceptable rate of return a company or investor requires from a project, typically reflecting the cost of obtaining funds and the risk associated with the investment. If a project’s calculated IRR is equal to or greater than the established hurdle rate, it is generally considered financially acceptable and worth pursuing.

Conversely, if the IRR falls below the hurdle rate, the investment may not generate sufficient returns to cover its costs or justify the risk, leading to its rejection. While IRR is a useful metric for evaluating profitability and comparing projects, it is typically used with other financial analyses, such as Net Present Value (NPV), for a more comprehensive assessment.