How to Calculate IRR in Banks

by Walter Johnson ; Updated July 27, 2017

The internal rate of return (IRR) for banks is no different than for other institutions of individuals. The purpose of calculating the IRR is to compare different investments that have different cash flows and have different initial investments measured with interest over time. The figure you receive from the IRR formula will be a good guide to compare different investment potentials over time.

Step 1

Gather your variables. The variables for both present value and IRR are your targeted rate of return, that is, how much you can reasonably expect from the investments in question, the interest rates, compounded rates over time, the length of the loan or investment, your initial investment, or how much you need to pay out to make the investment happen, and, finally, the cash flow you expect each time the interest rate is charged.

Step 2

Calculate the present value of the investment. This must be done before the IRR can be considered. The present value is the amount of money a bank will have to invest today to reach its targeted return later. For example, a bank wants $100,000 in 10 years from a small business loan If, over a 10-year period at a specific rate of interest, the small business will pay back $100,000. The concept of present value is how much the loan has to be right now so as to make $100,000 in profit 10 years from now. The formula is fairly basic: Present Value = Cash Flow / (1 + Interest Rate).

Step 3

Figure out the desired rate of profit. If the bank requires 10 percent to stay solvent, then this is the target figure. Your job now is to figure out what investment will most easily reach that 10 percent profit. Calculating the IRR derives directly from the calculation of present value. What you are doing is comparing your initial investment outlay with the present value of all future cash flows, both positive and negative.

Step 4

Write out the formula for IRR. It is: 0 = your initial outlay (written as a negative) + the first period in which interest is charged / (1 + IRR). Then this is added to the same for the next period, with (1 + IRR) raised to the power of n, with n equaling the number of periods. The answer must equal zero. The only variable you need to solve for is the IRR. Hence, the equation is based around figuring out, given your initial outlay and the profit that you seek, how much a rate of return is required to have the present value of your initial investment equal zero.

Step 5

Lay out your actual numbers in the formula. For example, your bank wants $10,000 profit from a small-business loan. The loan is spread out over three years. The initial outlay is $75,000. This is the amount of the loan before any interest is charged. Figuring out the IRR here would look like this: 0 = -$75,000 + ($10,000)/(1+IRR) + (10,000)/[(1+IRR)^2] + (10,000)/[(1+IRR)^3]. This represents the three periods interest on the loan would be paid. The second and third periods need to be raised to the second and third power respectively. A financial calculator will do that for you.

Tips

  • Compare the results of different investment options against your expected rate of return. If you need 10 percent to make a reasonable profit and keep your job, calculate the IRR multiple times, given all possible loans you are considering. If one result is .24, this is more than twice the 10 percent you expected. If another is .50, this is five times the amount. Go with the latter option.

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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