Internal rate of return is a rate at which the present value of cash inflow is equal to the present value of cash outflows, meaning we can say that our net present value is equal to 0. It is also reffered to as the cut off rate. Trial and error method is followed here for the calculation of Internal Rate of Return.

At first we have to discount the cash flows at random through any rate say 9 %. If the resultant NPV comes as positive then again discount the cash flows through higher discount rate to make NPV negative . After that we can use the interpolation method to calculate the Internal rate of return

Under this method lets assume the  first trial as 9%

year Cash flows discounting factor at 9% present value

1 8.75 0.917 8.023

2 11.30 0.842 9.514

3 14.90 0.772 11.502

  total  present value 29.039

Total present value at 9% comes as 29.039 which is more than the initial investment of 27.50.

Therefore, a higher discount rate is suggested as 13%

year Cash flows discounting factor at 13% Present value

1 8.75 0.885 7.743

2   11.30 0.783 8.848

3 14.90 0.693 10.326

total present value 26.917

Total Present value at 13 % comes as 26.917 which is less than the inititial investment. So, internal rate of return is more than 9% but less than 13% , meaning internal rate of return is somewhere between 9 % and 13%. The exact internal rate can be calculated through interpolation.

Internal Rate of Return = Lower rate + ( total present value of lower rate - Initial invement / total present value of lower rate - total present value of higher rate ) * difference between higher rate and lower rate

9 +( 29.039 - 27.50 / 29.039 - 26.917 ) * 4

  9+ ((1.539 /2.122)) * 4)

9 + 2.90

11.90

so, Internal Rate of Return is 11.90 %