Internal Rate of Return (IRR): Formula and Examples

Introduction:

Say you got a significant sum from a matured investment and plan on reinvesting, but this time in a small business. One says they are starting an AI-based fintech platform; the other plans to build an e-commerce platform. 

Both project financial figures and can leverage the industry growth, so which one should you invest in? How do you decide which one will give you better returns? 

This is where the Internal Rate of Return, or IRR, comes in. It’s like a financial crystal ball that helps you predict the profitability of an investment. Whether you’re an entrepreneur, investor, or finance enthusiast, understanding IRR can give you an edge in making smarter financial decisions, including growth equity investing. So, let’s break it down.

What is the Internal Rate of Return?

The Internal Rate of Return (IRR) is the percentage return a project or investment is expected to earn each year. It’s calculated as the rate at which the net present value (NPV) becomes zero. NPV is the difference between the money coming in (cash inflows) and the money going out (cash outflows), adjusted for time. Simply put, IRR shows how well an investment could perform over time.  

In capital budgeting, IRR helps find where the total cash inflows equal the initial investment, making the project worthwhile. In investment analysis, the internal rate of return is used to check if the expected return meets the investor’s minimum requirement, called the “hurdle rate.” A higher IRR generally means the investment will likely be more profitable, provided all other conditions remain the same.

While there are many ways to calculate expected returns, IRR stands out for evaluating growth opportunities. Think of it as the annual growth rate your investment might achieve. It’s similar to the compound annual growth rate (CAGR) that is usually computed using the CAGR calculator. However, in real life, investments rarely yield the same yearly return. The actual returns differ from the estimated IRR, but it still offers a solid benchmark for decision-making.

How to Calculate the Internal Rate of Return?

You can compute IRR using different methods-

Manual Calculation Using Internal Rate of Return Formula:

The internal rate of return formula is-

0=NPV=t=1TCt(1+IRR)t−C0​

Where Ct represents the cash flows for period t, C0 stands for the initial investment or the cash outflow, T is the total time, and IRR stands for the internal rate of return. The equation is solved to get IRR.  

For instance, say a company plans to invest Rs.10000 (C0) in a project and expects annual cash inflows of Rs.4,000 (Ct) for three years. The computation will be as follows-

0=4000(1+IRR)1​+4000(1+IRR)2​+4000(1+IRR)3​−10,000

A little trial and error or a few tips on the calculator will give you an IRR of around 14.5%. This means that the project’s annual return is around 14.5%. If this rate sits well with the company’s target, then the investment is worth considering. 

Through Excel:

Calculating the IRR in Excel is simple with the IRR function. It does all the work of finding the discount rate you need. For this,

• Enter all cash flows in an Excel spreadsheet. These include both positive (inflows) and negative (outflows) amounts. Then, arrange them in chronological order. Start with the initial investment (usually negative) and list the rest as they occur.
• Use the IRR function in the cell where you want the IRR to appear. The formula is: =IRR(values). Here, “values” refers to the range of cells with your cash flows. Be sure to include the initial investment as well.

For example, if your cash flows are in cells A1 through A6, with A1 being the initial investment and A2 to A6 the later cash flows, the formula would be: =IRR(A1:A6).

3. Some investors and investment advisory services use online IRR calculators for convenient and quick computation. 

What Is The Internal Rate of Return Used For?

• IRR is a useful tool for comparing the profitability of different projects. For example, an energy company may use IRR to decide whether to build a new power plant or expand an existing one. While both could add value, IRR helps identify which option makes more sense.
• IRR is also important for stock buybacks. When a company spends money repurchasing its shares, it must show that this investment has a higher IRR than other uses, like expanding operations or acquiring companies.
• Individuals can use IRR for personal financial decisions. For example, those with high IRR are more attractive when comparing life insurance policies because they offer better returns for the same premiums.
• Life insurance, especially early, has a high IRR—sometimes over 1,000%. If you only made one payment and passed away soon after, your beneficiaries would still get a large payout.
• IRR also helps analyze investment returns. It shows the assumed return, considering reinvested dividends or interest, and can be crucial when assessing complex investments like annuities.
• Lastly, IRR is used in calculating the Money-Weighted Rate of Return (MWRR), which factors in changes to cash flows during an investment period.

Drawbacks Of Using The Internal Rate of Return:

IRR has some drawbacks. Unlike net present value, it doesn’t show the actual return on the initial investment. An IRR of 30% doesn’t tell you if it’s 30% of Rs.10,000 or Rs.10,00,000. Relying only on IRR can lead to poor decisions, especially when comparing projects of different durations. For instance, if Project A has an IRR of 25% over one year, and Project B has an IRR of 15% over five years, using IRR alone could make you pick Project A, which might not be the better choice. 

IRR also assumes that all positive cash flows from a project will be reinvested at the same rate as the project instead of using the company’s cost of capital. This assumption can distort the project’s true profitability and cost. Financial analysts often use the Modified Internal Rate of Return (MIRR) to get a clearer picture. MIRR adjusts for the reinvestment rate, more accurately reflecting a project’s potential return.

Bottomline:

The internal rate of return (IRR) is a useful tool to estimate the return on an investment. It helps compare and rank different investments, showing which one might be the best. However, using IRR alone isn’t enough to make the right decision. Combining it with other tools and metrics is essential for a complete picture of any investment opportunity. The key is simple—stick to the share market basics, keep your research game strong, and consult registered financial experts to make the best decisions.

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