IRR stands for Internal Rate of Return, and it is a rate of return on an investment. IRR is a financial metric used to evaluate the profitability of an investment and is one of the techniques of Capital budgeting to assist in decision making.
It is a discounting cash flow technique which gives a rate of return earned by a project. The internal rate of return is the discounting rate where the total of initial cash outlay and discounted cash inflows are equal to zero. It is called ‘internal’ because it does not take any external factors like inflation or any other risk into consideration.
There are various methods to calculate IRR, each with its own strengths and applications and now we will discuss these methods.
- Trial and Error (Manual Method)
This methos is time consuming and not suitable for large cash flow working and here we manually test different discount rates to see which one makes the Net Present Value (NPV) of the cash flows equal to zero. This is often done by using a spreadsheet or financial calculator.
- Excel IRR Function
Using excel is the simplest way to determine the internal rate of return. Here you can easily enter your cash flows to get the desired discount rate. To access this feature, press the Formulas Insert (fx) icon.
Microsoft Excel has built-in functions for calculating IRR.
- Excel Formula = IRR (values, [guess])
- values are a range of cells that contain the series of cash flows, including the initial investment (which should be a negative number) followed by positive and/or negative cash flows.
- [guess] is an optional estimate of what you think the IRR might be, helping the function converge faster.
Remember that:
- The initial investment will always negative because it represents an outflow.
- Cash inflows in following years can be positive or negative.
- Specialized Software
- Many financial calculators have built-in functions to compute IRR. You simply input the series of cash flows, and the calculator provides the IRR. This method is super quick and accurate, and you can find one in the link: https://www.calculatestuff.com/financial/irr-calculator
- Financial Calculator
We can also use a financial calculator with IRR functionality. Enter the cash flows and use the IRR key to compute the rate.
- Newton-Raphson Method
This iterative method finds the IRR by approximating the rate where NPV equals zero. It uses calculus and iteration. Newton-Raphson method is a root-finding method that starts with a guess rate and then revises that rate after each iteration until function values convergence.
What is Good IRR?
Logically your investment must fetch a positive IRR as a negative IRR means you’d lose money on the investment. Second rule is ‘higher is better’ which means the higher is your IRR the more you would earn.
We can say that an IRR of 10% or greater is acceptable and below 5% IRR simply indicates that investor may reconsider other investment options. An investment with IRR of 18% to 20% would be considered as ‘Good’ but it also depends on nature of investment.
Example to Calculate IRR by Excel Function
Suppose we have an investment option where we will invest $1000,000 and
Expected Revenues $900,000 Yearly for 3 years
Expected Cost/Overheads $400,000 Yearly for 3 years
In this case we have a net cash inflow of $500,000 for 3 years (Rev $900,000 less Cost $ 400,000). Now we will place all these numbers in excel sheet and use IRR function as below:
Answer: IRR is 23.375%
IRR vs. ROI
Two of the most used financial metrics to evaluate investments are the internal rate of return (IRR) and return on investment (ROI). Both IRR & ROI are used for evaluating the viability of investment opportunities but their scope, calculations methods, and insights are different. ROI is a straightforward method to measure profitability on any investment. On the other hand, IRR is a bit complex and requires know-how of other financial concepts. We can say that Return on Investment (ROI) fails to capture the time value of money (“TVM”) and other aspects. Internal Rate of Return (IRR) offers a more comprehensive perspective by considering the time value of money, cash flow dynamics, and risk factors.
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Bottom Line
The purpose of all investments is to invest money and get more money, so all businesses use IRR to decide which projects are good for investments. When we are investing in a project based on our study or feasibility, only numbers we have are how much we will invest and what is expected returns so we use IRR to convert these outflows and inflows in percentage so we can decide whether investment is workable or not.
Simplest way to calculate IRR is by using tools like Excel, financial calculators, or specialized software.
ABOUT THE AUTHOR
Humayun Atif | CMA, CPA, CA (FIN), MS-IT, CA Articles from Big 4, Certified Forensic Accountant (USA), Six Sigma & Oracle Certified.
Atif is passionate about Business, Tech, and the written word. He is the author of the book ‘IFRS Made Easy’. He is a Tax and IFRS coach and the founder of accountingblogger.com
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