Economics and The Time Value of Money - Internal Rate of Return (IRR), Uneven Cash Flows and Serial Payments
Internal rate of return (IRR)
What is internal rate of return?
The IRR is essentially the interest rate that makes the NPV value of all cash flows equal zero. It represents the return a company would earn if it expanded or invested in itself, rather than elsewhere.
The internal rate of return used in time value of money calculations cannot be directly found by formula. It can be approximated by trial and error, but in the real world it is simply found by inputting present value, future value, and the number of compounding periods into a financial calculator. (To learn more, see What's the difference between net present value and internal rate of return?)
Uneven cash flows
The uneven cash flow method is used to calculate the annual payments needed to fund future college tuition costs. This method employs the cash flow keys on a financial calculator to determine the present value of the cost of college tuition over the period of attendance, usually four years.
The two steps:
- Calculate the present value of the cost of tuition over the four-year period.
- Calculate the annual payments that must be made to fund those costs.
A serial payment is a payment that increases at a constant rate. An example would be an employee who contributes a set percentage of salary each pay period to a 401(k) plan. Assuming the employee receives annual pay increases and maintains the same contribution percentage, the employee's 401(k) contribution is a serial payment that increases each year.
Another example of a serial payment is an annuity payment that increases regularly according to a set percentage, possibly to provide a hedge against inflation.