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The logic behind IRR

Personal Finance & Money Asked on January 19, 2021

I can’t still completely understand the logic behind the calculation of IRR.

It’s all clear with NPV. Let’s use simple example:

NPV = CashFlow / DiscountRate
100 = 110 / 1,1

But with the IRR…, the definition of IRR says:

"To find the IRR, you would need to "reverse engineer" what discount
rate is required so that the NPV equals zero."

In this case: 0 = 110 / x => x = 110 / 0

So, how can such a discount rate exist at all, if the solution requires the division by zero?

One Answer

The sum of the discounted cash flows (NPVs) should equal zero.

For example, you deposit £100 today (NPV) and expect to receive £110 next year. Discount £110 to NPV and sum the cash flows.

100 - 110/(1 + x) = 0

∴ x = 10 %

Answered by Chris Degnen on January 19, 2021

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