Thursday, April 14, 2011

Steps for calculating IRR

The following steps may be used to calculate internal rate of return using one of the financial calculators (HP 12C and TI BA II Plus):

1. Identify all external cash flows, including beginning and ending market values, and arrange them in chronological order.

2. Arrange the cash flows so that they are evenly spaced with respect to time. The financial calculators expect cash flows to occur at a regular frequency, so the cash flows entered must be evenly spaced, with zero cash flows used to fill in any missing data. I will describe how this can be done below.

3. Create the present value equation, equating the sum of the present value of outflows (beginning market value and any contributions) with the sum of the present value of in-flows (ending market values, and any withdrawals). I recommend ordering cash flows on each side of the equation in chronological order, from the first through to the last.

4. Identify simultaneously occurring cash flows. These are cash flows that occur on the same date, including both outflows and in-flows. These will be netted for purposes of entry into the financial calculator.

5. Using the appropriate keystrokes, enter the cash flows into the financial calculator’s cash flow worksheet, and compute the IRR.

6. The solution obtained in step 5 will be an internal rate of return for the interval of the cash flow spacing (step 2). Using exponents, convert the internal rate of return to a return for the desired period.

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