Internal Rate Of Return

What is IRR? Understanding the Internal Rate of Return

IRR is the annualised effective compounded return rate reflecting the return on investment achieved when the investment reaches its break-even point.

Written by : Daina Mathew

Reviewed by : Akanksha Gangvany

Akanksha Gangvany

2024-09-12

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10 minutes read

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There are a variety of ways to measure the performance of an investment. Some common methods include calculating the return on investment (ROI), net present value (NPV), and Internal Rate of Return (IRR). 

For evaluating investment prospects and prioritising business ventures, the Internal Rate of Return stands out as a crucial metric that helps in. If you are wondering what is IRR and how is it different from others performance metrics, then worry not! This blog will provide you with the details regarding the same.

Table Of Content:

What is the Internal Rate of Return (IRR) Meaning? 

The Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the expected return on an investment. The IRR is the discount rate that makes the net present value of an investment equal to zero.

It is also a good way to compare different projects within the same company.

When evaluating potential investment opportunities, investors typically opt for the highest expected return, represented by the IRR, which meets or increases the minimum percentage necessary for the investments. The higher the IRR, the higher the profit from the investment.

Did You Know?

IRR measures investment returns, both expected (ex-ante) and realised (ex-post).

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Example of IRR Calculation

Assume a project has an initial investment of ₹1,000 and is expected to generate cash flows of ₹200, ₹300, and ₹400 over the next three years.

The project's IRR would be calculated as follows: IRR = [₹200 + ₹300 + ₹400] / [3 * ₹1,000] = 0.14. In this example, the project has an IRR of 14%.

You should use the Internal Rate of Return when you are trying to compare different investments. It is a good way to measure the return on an investment, as it considers the timing of the cash flows.

 

Main Components of the IRR Formula

The Internal Rate of Return formula is a critical tool in finance that is used to evaluate the performance of an investment opportunity. It represents the discount rate at which the Net Present Value (NPV) of all cash flows from an investment equals zero. Let's break down the components of the Internal Rate of Return formula:

  • Net Present Value 
    Net Present Value or NPV represents the summation of future cash flows from an investment, discounted to their present value. NPV is set to zero to determine the IRR that renders the investment's NPV neutral, marking the break-even point.

  • Cash Flow 
    Cash flow consists of all monetary transactions associated with an investment, including inflows such as profits, revenue, or dividends and outflows like expenses, interest, or loan payments.

  • Number of Periods 
    The number of periods signifies the duration over which the investment extends. Time periods are usually discrete, such as years, quarters, or months, depending on the nature of the investment.

  • IRR 
    The Internal Rate of Return denotes the discount rate required to equate the present value of cash flows with the initial investment. 

  • Initial Investment 
    This refers to the upfront expenditure required to initiate the project or investment.

How to Calculate IRR? 

Now that you know IRR meaning, let's move forward to understand how to calculate the value. There are quite a few methods to calculate:

  • One popular method is to use IRR calculator, which can be found online

  • Another method is to use Excel, which has a built-in function for calculating IRR

  • Use the conventional formula on paper

Using the Financial Calculator 

  • Enter the cash flows for the investment, making sure to list them in chronological order.

  • Press the "IRR" button on the calculator.

  • Enter the required rate of return. This is the minimum return you would accept for investing.

  • Press the "Calculate" button on the IRR calculator.

  • The output will show the Internal Rate of Return for the investment.

Using MS Excel

  1. Enter your investment's cash flows in a table. Make sure to list all cash flows in chronological order and label the table appropriately.

  2. Determine the number of periods for your investment. This is the number of cash flows you have listed in your table.

  3. Calculate the interest rate per period. This is simply the interest rate divided by the number of periods.

  4. Use the IRR function in Excel to calculate the internal rate of return for your investment.

  5. Interpret your results.

A positive IRR indicates that your investment will generate a return greater than the interest rate, while a negative IRR indicates that your investment will generate a return less than the interest rate.

Using Math Formula
 

  1. Arrange the cash flow in increasing order, i.e., negative values first, followed by positive values.

  2. Calculate the cumulative cash flow.

  3. Use the following IRR formula for the calculation:

IRR = [∑(CFn * (1 + r)n)]/∑(CFn)

Where,

CFn = Cash flow for period n 
r = Rate of return 
n = Number of cash flows

Illustration:

Suppose a company is considering replacing its machinery. Here are the costs and returns associated:

  • Initial investment: ₹500,000

  • Annual incremental increase: ₹200,000

  • Replacement value: ₹45,270

  • Asset lifespan: 3 years

 

Assuming the Internal Rate of Return (IRR) to be 13%, the calculation would proceed as follows.

Year
Cash flows
Discounted cash flows
Computation

0

 

 

-5,00,000

 

 

-500000

 

 

(5,00,000 * 1) 

 

 

1

 

 

2,00,000

 

 

176991

 

 

2,00,000 * (1/1.13)1 

 

 

2

 

 

2,00,000

 

 

156229

 

 

2,00,000 * (1/1.13)2 

 

 

3

 

 

2,00,000

 

 

138610

 

 

2,00,000 * (1/1.13)3 

 

 

4

 

 

45,270

 

 

27765

 

 

45,270 * (1/1.13)4 

 

 

With the IRR formula, the sum of discounted cash flows approaches zero, resulting in an NPV of zero, indicating that the discounted rate is optimal. A rate of 13% minimises both positive and negative cash flows. Thus, it represents the best return on investment. The company's cost of capital stands at 10%. Given that the IRR surpasses this rate, the project is viable for selection.

formula

How to Use Internal Rate of Return (IRR) for Investments? 

IRR, or internal rate of return, is a financial metric used to assess the profitability of investments. To calculate rate of return, the investor must first determine the cash flows associated with the investment. These cash flows can be positive (inflows) or negative (outflows).

Once the cash flows have been determined, the investor must then calculate the IRR. The IRR is the rate at which the present value of the investment's cash flows equals the initial investment. In other words, it is the discount rate that makes the net present value of the investment equal to zero.

The higher the Internal Rate of Return, the more profitable the investment. For this reason, investors often use IRR to compare different investment opportunities.

Recommended Reading - What are Financial Assets?

When Not to Use Internal Rate of Return (IRR)? 

The Internal Rate of Return is a good measure to use when comparing investment opportunities, but there are some potential drawbacks.

  • The biggest issue with using IRR is that it assumes that cash flows are reinvested at the same rate. This may not hold good in the real world.

  • Another issue is that it does not consider the time value of money. This means that it does not consider the fact that money today is worth more than money in the future.

  • Finally, IRR can give conflicting results when there are multiple periods of positive and negative cash flows.

Internal Rate of Return Vs Net Present Value

IRR and NPV are two methods of investment appraisal.

IRRNPV
IRR indicates the discount rate at which the NPV of a project is zero.NPV is the present value of cash inflows from a project minus the present value of cash outflows.
IRR is a measure of the expected return on investment.NPV is a measure of the profitability of an investment.
IRR shows the percentage return that the project will yieldNPV shows money that a project will produce
IRR is focused on breaking even on cash flowNPV is focused on project surplus

Investments Where IRR Helps to Judge Performance 

IRR is a useful tool for judging your investments based on regular cash inflows or outflows. So, you can use this rate of return to estimate your returns from all the SIP investments or regular income plans like:

  • Mutual fund SIPs

  • Monthly Income Plans (or IDCW Mutual Funds)

  • Market-linked Pension Plans

  • National Pension Scheme (NPS)

Internal Rate of Return will help you estimate the actual return on your annuity or SIP which you can compare to lump sum investments or other investments declaring annual CAGR growth.

Do remember to convert your monthly IRR to an annual rate of return before you can compare it with CAGR or compounded annual growth rate.

You should also consider the different scenarios and components of the project. You must have a firm understanding of the risks involved in the project and the probability of success of the project. For more clarity on the potential impact of the project on your business, you should use multiple methods, to calculate the return on investment, before deciding.

Summary 

IRR’s capital budgeting metric helps generate the growth rate that a new project or investment option can generate. If the IRR exceeds the project's initial expenses, you must consider the investment option. Thus, the greater the project's IRR value, the higher the returns on investment will be. If you plan to make the right investment choice for better future growth, you can check out the investment options offered by Canara HSBC Life Insurance. Thoughtfully designed investment plans can help you to grow your wealth and stay financially secure during emergencies.

Glossary:

  • Net Present Value (NPV): NPV is a financial metric that calculates the present value of future cash flows generated by an investment, discounted at a specified rate. A positive NPV indicates the investment is profitable, while a negative NPV suggests it may not be.

  • Mutual Funds: This investment tool allows a pool of money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. 

  • ULIPs: ULIPs are investment-cum-insurance products offered by insurance companies. They provide both life insurance coverage and an opportunity to invest in various asset classes such as equity, debt, or a combination of both.

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FAQ’s For Internal Rate of Return (IRR):

IRR, or Internal Rate of Return, is a financial metric used to assess the profitability of an investment. It represents the rate at which the net present value (NPV) of cash flows from an investment equals zero.

A 20% IRR indicates that the investment is expected to generate a return of 20% annually, reflecting its profitability relative to the initial investment.

A 100% Internal Rate of Return suggests that the investment doubles in value, which may seem favorable. However, it's essential to assess other factors such as risk, time horizon, and sustainability to determine the overall attractiveness of the investment.

Yes, a negative Internal Rate of Return reflects that the present value of expected cash flow is greater than the present value of expected cash inflow at a time frame.

This rule states if the project or investment is greater than the cost of capital, the the project or investment can be pursued and vice versa.

Yes, IRR inherently accounts for compounding by considering the time value of money, reflecting the growth of investment returns over time through reinvestment of cash flows at the calculated internal rate of return.