INTERNAL RATE OF RETURN

IRR (Internal Rate of Return) Method takes into account the time value of money as we do in the calculation of NPV i.e. Net Present Value. It helps us to analyze an investment plan by comparing the IRR to the minimum rate of return required by the entity. Often referred to as the project yield, it is the rate at which an investment project assures to generate a return during its usable life and at which the PV of a project’s net cash outflows becomes equal to the PV of net cash inflows. In simpler words, we can say that IRR is the discount rate where NPV becomes zero.

In this article, we will discuss the concept of IRR in detail including its formula, calculation, example, and major aspects.

WHAT IS INTERNAL RATE OF RETURN i.e. IRR?

IRR is a financial phenomenon that assists in estimating the profitability of a potential investment project and is widely used in discounted cash flow analysis. It is the discount rate at which the NPV of a project becomes zero and tells the expected annual growth rate of an investment. It assists in comparing the potential annual return rate over tenure and is best suited for analyzing capital budgeting projects. While its calculation will yield the Present value of future cash flows as zero, thus it is the rate of interest that makes the PV of the estimated cash inflows equal to the PV of the cash outflow required by the investment.

For instance, while making an investment decision, if the IRR is greater than the required rate of return or cost of capital, then the project is a profitable option to opt for. On the other side, if the IRR is lower than the CoC, then the project won’t be an ideal option. Apart from IRR, many other quantitative and qualitative factors play their role while making an investment decision.

FORMULA AND CALCULATION

IRR uses the same formula as NPV

i.e.,

NPV = (Cash Flows/(1+r)^t) - I

Where,

Cash Flows: All the cash flows during the tenure of investment

R = IRR

t= Tenure

I = Initial Investment (FIrst investment made in the project)

IRR is the rate at which the investor will be in an ideal position i.e. profitable. Hence, IRR is the rate at which the present value of all future cash flows matches the cost of investment. While IRR can be calculated manually through a trial and error basis, one can also use the IRR function in MS Excel to ascertain the same.

For better understanding, let’s take an illustration.

There are 2 investment projects which require an initial investment of Rs. 10,00,000. A company has to opt between the 2 projects. The cash flows are as follows:

	Project 1	Project 2
Year 0	-10,00,000	-10,00,000
Year 1	2,00,000	6,50,000
Year 2	6,00,000	3,50,000
Year 3	2,50,000	2,00,000
Year 4	3,50,000	2,00,000

By using the excel function, the IRR of project 1 comes out to be 15% and project 2 gives an IRR of 20%. So now, if the company is to opt on the basis of IRR, they will go forward with project 2 as it offers high IRR and is more desirable.

Points to remember

The figures included should be a set of positive and negative values.
Amount invested in the project should be shown in negative figures.
The amount received should be shown in positive figures.
All investments are done at regular intervals.
All the payments have been assumed to be made on a yearly basis.

WHAT DOES IRR INDICATES?

IRR, to be termed as layman language, evaluates investment returns and is used by entities to determine which project is ideal and more profitable to invest in. As IRR is calculated as a percentage it makes it easier to compare it with the company’s financing cost. And if the cost is less than the rate of return that the project can be opted for.

This concept is majorly applied with WACC (Working Average Cost of Capital) and NPV (Net Present Value). As we discussed earlier, it is a discount rate at which NPV is zero. This indicates that at zero NPV, the value of IRR will be more than the WACC.

In theory, what we study is that the project with higher IRR should be opted for. But in practicality, usually, companies determine the minimum required rate of return referred to as RRR and this rate is compared with IRR and if the IRR is greater than this, then the project is considered.

IRR & MUTUAL FUNDS

Apart from playing a key role for businesses to evaluate different investment opportunities, IRR is also used by many investors as a phenomenon to calculate the return on their investments. Actual SIP returns can be calculated by investors investing in MF through SIP by using IRR. In excel, this can be done by using the XIRR function.

LIMITATIONS OF IRR

1. Assumption of reinvestment:

IRR assumes that the cash flows generated are reinvested at the same rate as that of the project’s IRR rather than at the CoC. Thus, it may not give the correct representation of profitability. To counter this, MIRR i.e. Modified Internal Rate of Return can be used as it is considered as the reinvestment rate.

2. Economies of scale is ignored:

One drawback of the IRR is that it ignores the actual money value of benefits. One should always prefer a project value of Rs.1,00,00,000 with a 19% return over a project value of Rs. 1,00,000 with a 45% return. There is no need for in-depth analysis as we can see the former will reap more benefits. But here, the IRR will rank the latter project—with a much lower benefit—first, simply because the IRR of 50% is higher than 18%.

FAQs

1. What is IRR?

IRR is a financial phenomenon that assists in estimating the profitability of a potential investment project and is widely used in discounted cash flow analysis.

2. What is the formula to calculate IRR?

IRR uses the same formula as NPV

i.e.,

NPV = (Cash Flows/(1+r)^t) - I

Where,

Cash Flows: All the cash flows during the tenure of investment

R = IRR

t= Tenure

I = Initial Investment (FIrst investment made in the project)

NPV = 0 (Zero)

3. What are the limitations of IRR?

The limitations of IRR are that it does not consider the tenure of the options and reinvestment rate.

4. How can IRR be calculated through excel?

IRR can be calculated by using the IRR function in MS Excel by putting correct values.

5. How IRR is helpful in Mutual Funds?

Actual SIP returns can be calculated by investors investing in MF through SIP by using IRR. In excel, this can be done by using the XIRR function.