An annuity is an investment that pays a set amount of cash flows over every period. When making decision to invest in an annuity, its internal rate of return (IRR) should be above the returns for other investments opportunities. The IRR is the rate of return that would make the net present value of cash inflows and outflows of the annuity or an investment project equal to zero. Thus, IRR is one of the fundamental calculations for corporate capital budgeting decisions.
Enter your initial capital contribution in the annuity. Your initial investment should be entered as a negative, as this is a capital outflow. You can use a spreadsheet program like Microsoft Excel to also calculate IRR of an annuity. Start by entering the capital outflow as a negative in one column.
Enter all the cash flows for each year. Since these are inflows, the amount should be positive. If you are using a spreadsheet, enter cash inflows in the rows beneath your capital investment.
Hit function IRR key on your financial calculator. Using a spreadsheet, select the cells containing your values, and enter the formula for IRR, which looks like this: [=IRR(A1:A6)]).
Using the steps above, the IRR of an annuity costing $1,000 and paying $400 per year for five years is 28.65 percent. If you are looking at different annuities, select the one with the highest internal rate of return.
The IRR is the rate the makes the net present value value of future cash flows equal to its current market value, returning a zero value. Technically, you can attempt to manually calculate the IRR of an annuity by plugging in different rates of return that will produce a net present value of zero; however, this is a labor-intensive process that could take hours.