[Rich76_911s]

I learn best following through an example vs. reading an explination so here is my example for you:

First let's answer what is present value. Say what is the present value of receiving $500,000 in two years, if interest rates are at 5%?

The present value equation is: Present value = (Amount being received) / (1+interest rate)^Raised to the # of periods

The present value is how much you should pay for one payment of $500,000 in two years @ a 5% interest rate is:
[(500,000)/(1+.05)^2] = $453,514 <--- Receiving this today is equivalent to receiving $500,000 in two years. (IF interest rates are 5%.)


If instead of one payment you have a series of cash flows going into the future, say:

Year 0: -$1,000,000 (your initial cash purchase price)
Year 1: $300,000
Year 2: $200,000
Year 3: $400,000
Year 4: $450,000
Year 5: $525,000

We are going to find the present value (what they are worth today) of each of those cash flows and sum them up.

Year 0: is worth exactly -1,000,000 it is todays value
Year 1: is [(300,000)/(1+.05)^1) = 285,714
Year 2: is [(200,000)/(1+.05)^2) = 181,405
Year 3: is [(400,000)/(1+.05)^3) = 345,535
Year 4: is [(450,000)/(1+.05)^4) = 370,216
Year 5: is [(525,000)/(1+.05)^5) = 411,351

The net present value of this series of cash flows is:
-1,000,000 + 285,714 + 181,405 + 345,535 + 370,216 + 411,351 = 594,221

So a million dollar investment today will net you $594,221 in profit.

The internal rate of return (IRR) is the interest rate that makes the series of cash flows worth zero. So instead of using 5%, we are finding the interest rate that would be the breakeven point for this series of cash flows.

The math to find IRR is simply setting all those equations above up without an interest rate and setting the NPV to zero, then solving for the interest rate. (MUCH EASIER DONE ON A CALCULATOR, or in excel)

IRR of the example is: 21.915%
**So if you go up to my equations above and replace each "1+.05" with "1+.219" the net present value should equal ZERO

What this is telling you is if you can borrow at below 21.9% my example would be a profitable enterprise.