The internal rate of return (IRR) is a metric that estimates an investment’s future return rate. It’s an expectation, not the actual real achieved investment return. People also sometimes use the term IRR as a synonym for interest.
IRR is an annual growth rate and it’s expressed in percentages. It helps investors analyze profitability and choose between different business options. Another name for IRR is the discounted cash flow rate of return (DCFROR).
It’s called internal because it doesn’t take external factors into account. Some of those factors are political uncertainties, cost of capital, and inflation. Besides big projects and investments, it can come in handy in everyday finance too. It’s useful for people looking into buying a house or those who want to figure out their mortgage.
Answering what a good IRR is isn’t straightforward. It very much depends on the type of project, the industry, as well as the needs and expectations of investors.
One opinion is that a high IRR rate is always better. A high IRR would mean a high return. In other words, the return rate exceeds the cost of capital by far and creates future profit.
But, to determine what a good IRR is, it’s important to get more details about the project.
For example, if a company’s IRR is high but its cost of capital is even higher, it won’t be a profitable investment. In this case, a high IRR on its own doesn’t mean anything. That’s why experts always compare IRR to industry averages and to the cost of capital.
Another thing to consider is the duration of the investment. This is tied to personal preferences and needs. So, what a good IRR means to you depends on when you want to receive money back. If you’re not in a rush to get it back in the first year, waiting a few years might result in more profit.
The actual value of the project is crucial. If you invest 1 dollar and get 2 dollars in return, the IRR will be 100%, which sounds incredible. In reality, your profit isn’t big. So, a high IRR doesn’t mean a certain investment will make you rich. However, it does make a project more attractive to look into.
Net present value (NPV) and IRR are often mentioned together. The reason is that they’re both used for evaluating how lucrative a project is. Let’s explain what NPV actually is and how it’s different from IRR.
NPV is the difference between the market value of an investment and its total cost. In other words, it’s the difference between the current cash inflows and outflows. One of the definitions of IRR is that it's the rate at which NPV equals zero. So, when the market value and total cost are the same.
When it comes to NPV values, it’s rather simple. When the value is positive, the project in question will make money. That means that the market value is going to be bigger than the total cost. If it’s negative, it’s going to result in a loss for the investor.
Another contrast is that NPV shows the dollar amount that a project or investment will bring. IRR uses percentages to show the estimated return.
Both IRR and NPV can help investors make a decision, but sometimes they show the opposite things. In those cases, experts suggest relying on NPV instead. IRR doesn’t consider certain factors, such as changing discount rates. NPV does, and that’s what makes it more precise.
There are plenty of examples of NPV usage in real life. One of them is flipping properties, such as apartments or apartment complexes.
The investors’ first step would be finding the market value. That would be the average price of a renovated property similar to the one they’re interested in. Then, they would calculate the total cost. That is the cost of buying, renovating, and selling the said property.
Like we mentioned before, NPV is the difference between the market value and the total cost. So, by subtracting those two, the sponsors can see if the NPV is positive. That's an indicator of a good investment.
Businesses use IRR to determine if they should accept or reject a future project. They will reject it if it’s lower than the company’s required rate of return. If it’s bigger, chances are that they’ll accept it. It also helps compare the profitability of two or more potential investments. Most companies won’t rely on IRR only when making big decisions, but it’s a good starting point.
IRR is also popular with the retrospective estimation of investments. It’s frequently used with private equity funds, especially hedge funds. It evaluates how the fund performed and it’s part of its track record.
You can calculate IRR manually, through trial and error, or with the help of special software. If you choose the first method, it’s usually going to be difficult and time-consuming. Basically, there is no simple IRR formula, so you have to calculate IRR from NPV. The goal is to find a rate at which NPV equals zero.
The calculation looks like this:
|0 (NPV) = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n|
IRR and NPV are familiar terms, but here’s an explanation of the rest of the symbols:
- P0 - initial investment
- P1, P2, P3, etc. - cash flows in periods 1, 2, 3…
- n - holding periods
If you have to also calculate NPV first, you can use this formula:
|NPV = (Cash flows) / (1+r)i|
So, you need cash flows in a certain period of time. The other two values, r and i, are the discount rate and the period in question.
Microsoft Excel is one of the most popular tools for calculating IRR. It has three functions that make this process much easier than the manual one. They are the IRR function, the XIRR function, and the MIRR function.
The IRR function determines IRR by using a sequence of cash flows, while XIRR is more precise. It pays attention to the length of payment periods, so you must also enter specific dates. The MIRR function also considers the interest from the reinvestment of money. That’s why its result is different from the one you would get with the IRR or XIRR functions.
You can choose between using one of the IRR formulas Excel already has or you could be more analytical. This would mean calculating the steps one by one and using the results as inputs to the IRR formula. It’s more complicated and detailed, but it’s also easier to go over.
Here’s what the process of calculating IRR with Excel’s IRR formula looks like:
Open an Excel sheet and write down the original amount invested or the initial cash flow. This number has to be negative. For example, if your initial investment is 100,000 USD, enter -100,000 into the appropriate field. In this case, it will be the A1 cell.
Enter the cash flow values for every period into the subsequent cells. So, A2, A3, and so on.
Once you do that, click on the first empty cell. If the last cash flow value is in cell A9, click on A10. Then, type in the command “=IRR(A1:A9)” and press Enter. You should see the IRR result.
Like mentioned before, there is no basic formula for calculating IRR. But, if you don’t want to use the manual or the Excel method, you can use an online IRR calculator.
You will usually have to enter the initial investment, the cash flows, and the currency. Some need more data.
Remember that calculators may not show identical results. This doesn’t mean that some aren’t working. Instead, since IRR is an estimate, neither of them is necessarily wrong. After all, even Excel's different functions don't match, so don't expect complete precision.
Return on investment (ROI) is a metric related to IRR. Both measure the profitability and efficiency of investments. They’re often used for similar reasons, but there are some key differences between them. Based on them, you’ll decide when to use which metric.
ROI shows the total return of money an investor would get. It does so by comparing the present and original value of an investment. It will reveal either an increase or a decrease in profit. Like IRR, it’s a percentage rate.
While IRR focuses on annual growth, ROI calculates all of it. But, if you only calculated ROI for one year, it would be the same number as IRR. So, if you only want to know short-term results, calculating IRR should be enough.
Unlike IRR, there is an exact formula for calculating the ROI percentage. It’s much easier to calculate than IRR. The formula looks like this:
|ROI = [(Expected Value – Original Value) / Original Value] x 100|
For the best results, it’s good to use both of these metrics at once. The weakness of ROI is that it doesn’t consider the time value of money. Money today won’t have the same worth in the future, but ROI doesn’t take that into account. But, it’s not as complex and time-consuming as IRR, so using it has many advantages.
IRR is important in corporate decisions, but it can come in handy in personal finance as well. If a company can calculate it for future estimates, so can individuals. They often use it for mortgages and family investments.
IRR is becoming popular with people looking into buying or renting houses. For example, those that want to buy a house and then rent it out will use this method to find the most profitable one. It depends on the price of the house and the rate of rent. Since IRR is an estimated annual return rate, it can help calculate when each investment will pay off.
When it comes to mortgages, IRR depends on the initial payment, the number of payments, and the amount. Just use the regular formula since you have all the values. The initial payment is the positive inflow, while the monthly payments are negative.
IRR has many uses, especially when combined with NPV. Other than being good when buying properties, it’s also used for investments within a company. For example, when making decisions about buying equipment.
Quality equipment is important for business growth. When you buy a new piece of equipment, it’s usually a very large expense.
Sometimes it’s necessary to calculate whether it’s a good investment in a certain moment or if it should wait. You also have to take into account how long the machine would function. If it’s good, it will pay off over time. IRR helps predict how fast that will happen. It also compares it to other potential investments and helps those in charge make a pick.
First, the investor would estimate how much profit the equipment would bring. Also, they would determine if they could sell it for a good price once they’re done using it. Those are the factors that will make a difference in the final calculation.
If they’re using the trial and error method, they would start by setting the NPV value to zero and using the formula. Once they get the IRR of the other potential investment too, they would compare them. If the equipment IRR is 30% and the other one is 15%, the first one is the one they would pick. Even if it means they’ll initially have to give more money, IRR shows the real state of things in the future.
IRR can be a good starting point for future projects and investments. It’s a useful tool, but it’s not something to rely on completely. It can be misleading and, after all, it’s an estimate.
One of the limitations is that IRR favors smaller investments. Small projects may seem more profitable if you only look at the IRR percentage. A larger project will often have a lower IRR but will end up bringing more money when you look at the actual figures.
For example, on paper, a 50% return on a 100 USD investment will seem better than a 20% return on a 100,000 USD investment. In reality, the benefit of the second one is 20,000 USD, while the first one brings only 50 USD. That’s why IRR only works in combination with other metrics.
Also, when it comes to real estate investments, it’s hard to predict the future value of properties. Experts try to make estimates, but past values are not always a good indicator.
When it comes to long-term projects, many factors can change the course of action and change its value. IRR can be accurate with short-term projects, but long-term ones won’t have the use of relying on it.
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