Internal Rate of Return (IRR) is the interest rate (can also be called as discount rate) at which the net present value of all the cash flows (both Positive and Negative or Cash Inflow and Cash Outflow) from an investment or project equal zero. Seems complex definition, right! Let’s make it simple then;
We will analyse above definition of IRR and verify the same with NPV
Here C0, C1, C2. . . Cn equals the cash flows (both inflow & outflow) in periods 1, 2, 3. . . n, respectively; and i is the internal rate of return i.e. discount rate.
IRR is also a measure of your investment performance, and is expressed as percent return per year. It takes into account the amount of time that has elapsed since making an investment. For example, if you purchased Rs. 1,00,000 worth of stock today, and one year from today its market value is Rs. 1,20,000, your gain would be 20%. Your IRR would also be 20%, because exactly one year would have elapsed since you made the investment. This can very well be calculated with the help of Microsoft Excel with the following formula;
This formula is useful till you have only one inflow and an outflow, but this will not work if there are multiple inflows & multiple outflows. In such scenarios you can use following Microsoft Excel function;
IRR is usually used to calculate the profitability of investments made in a financial product or projects. Higher the IRR, the more profitable it is to invest in a financial product or project. Assume all financial products require the same amount of up-front investment, the product with the highest IRR would be considered the best. Let us understand through an example;
Suppose you have been approached by 2 investment options such as Investment A & Investment B with the following Initial Contribution and future payouts (receivables);
The table above for the two investment shows, even if Investment A & Investment B are paying back Rs. 32,00,000 over next ten years respectively for the same initial contribution of Rs. 20,00,000, but Investment B seems to be a profitable one, as its IRR for ten years is at 10.43% per annum compare to 9.84% per annum for Investment A. This helps to validate the cases with regards to real returns where you are being approached by some investment proposals with lucrative payouts. With an IRR calculation you will be able to figure out how much worth is the future payout(s) of an investment over a period of time and whether the expected receivables are more than what is already possible to get from your existing investments.
IRR can also be used to calculate expected returns on stocks or investments, including the yield to maturity on bonds. It calculates the yield on an investment and is thus different than net present value (NPV) value of an investment. IRR is best suited for analysing the returns of traditional moneyback/endowment plans, ULIPs etc. This also helps to ascertain the performance of venture capital and private equity investments, which typically entail multiple cash investments over the life of the business, and a single cash outflow at the end via IPO or sale.
With many advantages of IRR, there are also certain limitations with the formula. IRR gives a compounding rate of returns (yearly) for an investment which is assumed to be invested (or re-invested immediately) till maturity. Here the cash flows should be periodic i.e. the time interval between two cash flows (whether inflow or outflow) should be equal. In case there are irregular flows of investments or withdrawals then it becomes difficult to arrive a correct figure of IRR. Just like mutual fund investments which has many investment inflows, redemptions, dividend income whether payout or re-investment etc and nothing is periodic. For such complex situation XIRR will be useful to know the real rate of returns.
In my next post I will come up with how to calculate XIRR and usage of the same. Stay in touch.