Internal Rate of Return in Investments and its Significance
Internal Rate of Return (IRR) is a metric that can be an incredibly important measure of the success of a proposed investment. But what does the IRR tell you?
Investments are done for the sole purpose of wealth creation. The performance of any investment is measured through many metrics. The ones that are the most highly regarded and favored are return on investment (ROI) and internal rate of return (IRR). The primary reason why ROI is noticed more than IRR is because the latter is rather confusing and difficult to calculate when compared with the former.
What is the IRR?
A cost-profit analysis is a natural step before undertaking any new project or investment. The Internal Rate of Return is simply one such element in the broad realm of profitability ratios. IRR is also referred to as a discounted cash flow rate of return. It is a discount rate that supposedly equates the Net Present Value of all cash flows - inflows as well as outflows. One can also understand it as the estimated CAGR (compounded annual growth) of a particular cost.
Any project or investment has a margin or a required rate of return (RRR) that makes the undertaking worth considering. By virtue of being a profitability measure, the IRR of such an investment or project should be equal to or more than the RRR for an investor or a company to at least consider the prospect. Though that is not the only yardstick by which such decisions are made. Many other quantitative and qualitative aspects are taken into account before moving forward with an investment decision.
IRR in formulaIRR in formula
The formula used for the Net Present Value of cash flows is inherently the same one used for calculating the Internal Rate of Return. The major differentiating factor lies in the aspect that the underlying principle of the usage of NPV and IRR is different. Thus, IRR is derived through trial and error and not really through hard headed analysis. IRR is useful where the cash flows are variable for each period of investment. Going by that, the formula for Internal Rate of Return is as follows -
0 = CF0 + (CF1/ 1 + IRR) + (CF2/ 1 + IRR)^2 + … + (CFn/ 1 + IRR)^n
The numerals from 0 till n denote the investment periods and CF stands for the cash flows that happen during those periods.
The initial cash flow CF0 is always negative since it is an outflow. The subsequent cash flows can be either negative or positive. Using a spreadsheet or other specialized software to calculate IRR is always better since it helps in avoiding human error and confusion.
IRR at the end of it all is still based on speculation. It might differ from actual profitability. It simply indicates the plausible profit if everything goes fine according to all other aspects of financial modeling and analysis of an investment.
Going solely by the IRR helps analysts gain a rough understanding of which investments or projects might be better than others, without doing a deep dive into other financial aspects. Combined with NPV, IRR can provide good insights into the feasibility of an investment or a project in the long run. A high IRR with a low NPV might indicate substantial annual growth but very less value addition to the investor/company. Conversely, a low IRR but a high NPV indicate that the returns might be slow but the value addition would be significantly higher. This is ideal for projects of long durations.
When should you be concerned about IRR
As mentioned earlier, only if your investments vary across a period of time, IRR would mean anything to you. Mutual funds with several annuities across different periods would be an ideal subject for calculating IRR. However, if you are investing in something like real estate, the presence of IRR is just a reassurance that your investment is going to hold good for the long term.