IRR (Internal Rate of Return) is one of the profitability ratios which calculates the rate at which an investment is able to generate annualised returns (in percentage) on the invested (principal) money over a period of time.
IRR is used to calculate returns when principal money is invested and/or withdrawn at regular intervals, at the end of the year (as IRR calculates annualised returns).
It takes into account principal inflows and outflows at the end of the year and provides a return in a way that the net present value of future cash flows is zero. It also recognizes the time value of money.
What is XIRR?
XIRR (Extended Internal Rate of Return) is used to calculate returns when money is invested and/or withdrawn at different points of time throughout the life of investment, or with different figures, or both.
It takes into account principal and cash inflows and outflows throughout the tenure of investment and provides a return in a way that the net present value of future cash flows is zero.
Like IRR, it also recognizes the time value of money.
XIRR and IRR are quite similar, the only differences being that :
1. XIRR considers the dates when changes in principal take place, whereas in IRR, principal is rolled over (considered) annually and not from the effective date.
2. XIRR also calculates cash flow, whereas the same is not considered at all in IRR.
Thus, XIRR provides a more accurate and practical rate of return, and using IRR leads to wrong conclusions where the amount of principal money changes and cash flow (inflow or outflow) takes place anytime within the year.
The difference between both can be seen with a simple example :
• Company "K" has invested INR 25,000 in a project on 10/04/2020.
• The project provided a return of INR 10,000 on 10/04/2021.
• The project provided a return of INR 15,000 on 05/11/2021
• The project provided a return of INR 12,500 on 02/04/2022
• The project provided a return of INR 21,000 on 17/12/2022
Here, the returns as per both calculations are :
IRR : 40%
XIRR : 58%
Why is IRR great?
While methods like CAGR can find returns on a fixed principal amount over a fixed period of time, they are not effective and accurate when people want to make investments over fixed intervals, such as in SIPs.
Because CAGR and other calculations do not count the additions and/or withdrawals, they lead to inaccurate results to investors, which can significantly impact their investment decisions.
The reason IRR is required is that it can reflect precise returns an investor can earn when the principal money is invested and withdrawn on an annualised basis.
Why is XIRR great?
While IRR is very helpful in finding returns when investments and withdrawals are made at fixed intervals, it is not effective in more practical situations, where people regularly invest and withdraw principal money in and from their investments, such as Equities, Open-ended Mutual Funds, Bank Deposits, ETFs... the list goes on.
Because methods such as IRR do not count returns while considering additions and withdrawals at irregular intervals as well as cash flows, they also lead to inaccurate, and so, misleading returns, which can create a huge opportunity cost, and in turn affect the investment portfolio of small and even institutional investors.
This is the reason there is a requirement of XIRR, which provides precise returns when cash flow is involved and the principal money is not constant throughout a time frame (year).
What IRR should be used for?
Where people make investments at regular intervals out of their savings to build up their portfolio, IRR helps them calculate the returns on their investment. A great example of the same is investing in SIPs.
What XIRR should be used for?
XIRR is a wonderful tool for investors who do not invest and forget, who like to actively manage their portfolio by adding and pulling out their invested money.
The significance of XIRR is that it helps investors in making the financial decisions most suitable for their priorities and needs. The general notion is that if a particular investment fetches more returns than the opportunity cost, or expected or required rate of return, the investor invests in the vehicle.
XIRR is most widely used for analyzing capital budgeting projects.
When IRR should not be used?
IRR, although beats the traditional methods of evaluating the returns, cannot be used in cases where cash flow is involved.
Because IRR does not count the changes in values in between the year, it does not consider cash flow (returns) on the principal money as well as changes in principal itself. Therefore, when an investor needs to calculate compounded returns, which can be as simple as considering quarterly interest in a bank savings account, IRR does not work.
Also, it is not very useful practically for active investors and for investors who like to invest for cash flow rather than, or along with, capital gains.
When XIRR should not be used?
Although XIRR is one of the most accurate tools to calculate returns with variables in amount and time frame, it, of course, cannot be used everywhere and in every situation.
As XIRR is used to calculate the returns based on changes in principal amount and cash flow, it is not that valuable when the principal and tenure of investment remains fixed, such as an investor parking money in a 5 year close-ended mutual fund scheme.
Also, if the investment goes wrong and the cash flow in the future is not enough to cover even the principal money, then XIRR cannot be found at all. In a world where most businesses and investments fail, XIRR is not something you can rely on if things go sideways.
We hope that this article helped you understand more on the basics of IRR and XIRR, and the difference between the two.