What Is IRR?
If you are a Grip Invest user or have made any alternative fixed-income investment, you might have heard “IRR” often.
You must be wondering why there is another term for return when we already have CAGR, ROI, and Yield. And why is the term IRR not typically used for other investment options like FDs or mutual funds?
This blog will explain IRR, its use, and how it is calculated to help you make investment decisions based on your financial goals.
What Is The Internal Rate Of Return?
Every investment is a series of outflows and inflows of money. When you invest, there is an outflow, and every time you receive a return, it results in an inflow. These returns, however, may come all together or be spread across multiple points of time, sometimes over years. We all know that INR 100 received today is more valuable than the same INR. 100 received after 6 months, i.e., there is a time value to money.
Unlike under measurements, the Internal Rate of Return, or IRR, factors in the timing of returns and the number of returns received. It is a preferred way of measuring investments, especially those with returns received over a period of time, such as SDIs.
Why Use IRR As A Metric?
- Accounts For Timing: IRR considers the timing of cash flows. Hence, it provides a better overview of the investment’s performance. For example, an investment that generates a 5X return in 2 years will have a better IRR than an investment that gives a 5X return in 3 years.
- Ease Of Comparison: IRR helps investors compare returns from different opportunities. This enables investors to decide where to allocate their hard-earned money.
- Applicability In Various Sectors: IRR is flexible and can be applied in various industries and investments.
Calculation Of Internal Rate Of Return In Excel
Investors can easily use the IRR function in Excel to calculate the internal rate of return. This function works best in cases where the cash flows are spaced at equal intervals, preferably annually.
Here’s the Excel formula:
=IRR(cashflow amounts, [guess])
- Cashflow amounts: Here, you will select the series/array of cash flows, both investment outflow and returns received. Every series cell would be negative (initial investment) or positive (returns received).
- Guess: This will be an estimate of the IRR. It is optional and can be ignored while calculating in Excel.
Example of IRR calculation using Excel
What If Cash Flows Are Irregularly Spaced?
In such a case or cases where the date of payouts is given, it is better to use the Extended Internal Rate of Return, XIRR function. It measures the return on investment when cash flows are irregular.
You can calculate this easily in Excel using this syntax:
=XIRR( cash flow amounts, cashflow dates, [guess])
XIRR considers the dates when cash flows occur. On the other hand, IRR rolls over cash flows into annual periods.
Example of XIRR calculation using Excel
Note: Here’s a link to the Excel sheet demonstrating IRR and XIRR calculations.
What Is The Mathematical Formula To Calculate IRR?
IRR= (Future Value/Present Value)^1/n - (1)
n= number of investment periods.
It is the rate of return where the net present value of the project or investment is zero.
IRR Vs. CAGR Vs. ROI
| Basis Of Difference | Internal Rate Of Return (IRR) | Compounded Annual Growth Rate (CAGR) | Return On Investment (ROI) |
Timing Sensitivity | It takes into account the timing of cash flows. It considers both negative and positive cash flows | It ignores the timing of cash flows. Simply, it looks at the investment's beginning and ending values | It does not consider the timing of cash flows and gives an idea of the overall return |
Most Relevant to Use When | Returns are spread across multiple periods; Returns include not only interest but also the return of principal | When returns come all in one go and the tenure of investment is longer than 1 year | When returns come all in one go, and tenure of investment is usually around 1 year |
Calculation Difficulty | Due to multiple cashflows, manual calculations are not easy and best to be calculated using Excel | It is a simple method | It is easy to calculate
|
Formula | IRR= (Future Value/Present Value)^1/n - (1) n= number of investment periods | CAGR= (Ending value - Beginning value)^1/n - (1) n= investment period | Net Income/Cost Of Investment * 100 |
Purpose | To evaluate the correct profitability of an investment with several cash flows | To measure the mean annual growth rate of an investment, smoothing out volatility | Used to assess the efficiency of investment by comparing returns to cost |
Understanding IRR is crucial when comparing different investment options. If you're looking for fixed-income opportunities with predictable cash flows, explore rated and regulated investment options available on Grip Invest.
Example
The table below shows the year-on-year cash flows for an investment of INR 100.
If the investment period is 1 year, the ROI, IRR, and CAGR remain the same. However, if the cash flows are spread over 5 years, the ROI, CAGR, and IRR calculation changes.
Note: The table shows the cash flows in these 5 years, both negative and positive, to calculate IRR.
Why Is IRR Not Commonly Used For Investments Like FD or Mutual Funds?
FDs and Mutual Funds typically provide returns only at the end of the investment tenure. While some FDs and Mutual Funds will provide monthly/ quarterly interest or dividend payouts, this is a fairly small amount compared to the total principal. CAGR or ROI works well to measure the performance of such investments. IRR can, however, still be used and will provide a relevant comparison of returns vs. IRR on other investments in your portfolio.
Limitations Of Using Internal Rate Of Return
IRR assumes that positive cash flows are reinvested at the same rate as the IRR. Investors must note that IRR is not the same as CAGR or ROI and cannot assume that their investment compounds
Conclusion
In summary, the internal rate of return (IRR) is an important metric to evaluate an investment's profitability. Understanding IRR can help investors analyse opportunities better. However, it is essential to interpret IRR and other factors like risk tolerance and market conditions.
Online discovery platforms like Grip Invest offer rated, regulated, and listed investment opportunities with up to 16% pre-tax IRR. Our ‘Visualise Returns’ feature lets you see exact cash flows, so you do not have to calculate!
Frequently Asked Questions On IRR
1. What is a good internal rate of return?
What constitutes a good IRR depends on many factors. These factors include the industry, investment type, risk involved, etc. Hence, IRR should not be considered in isolation but in conjunction with other factors. Generally, the higher the IRR, the better it is.
2. Is ROI the same as the internal rate of return?
The significant difference between IRR and ROI is the time value of money. ROI gives you the total return of an investment but does not consider the time value of money. For example, INR 1,000 received today is more valuable than INR 1,000 received after three months. While IRR calculations take into consideration when the INR 1,000 was received. IRR represents the amount of money earned and how fast it was earned.
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