November 18, 2024
4 mins read
The internal rate of return or IRR is one of the most useful financial metrics to understand the return-generating potential of a project. In financial terms, IRR is the discount rate at which a project’s net present value is zero. By comparing the IRR of two projects, a manager can decide which one to invest in. Hence, IRR helps companies allocate capital to projects that have better return-generating potential than other projects. As IRR is expressed in terms of percentage, it is simple to understand and interpret. While it has many benefits, it has a few limitations as well. For example, if two projects have vastly different durations or cash flows, then IRR cannot be used to compare them.
The internal rate of return (IRR) denotes the return an investment can generate. While calculating it, we exclude external factors, like cost of capital and inflation. Hence, it is called the “internal” rate of return.
IRR is extremely important, as it helps business leaders assess the profitability of an investment. In most cases, an investment with a higher IRR is better than another with a lower IRR. Read this blog, as it explains the meaning of the internal rate of return, how the internal rate of return works, and many other aspects related to it.
Let us understand the meaning of the internal rate of return in detail. Suppose a company is thinking of investing in a factory. It knows how much it will have to spend on building it, which is known as capital expenditure. This capital expenditure is cash outflow on this project as of today.
The company will have to estimate the future cash inflows from the factory. Typically, such inflows are estimated for each year. Let us say that the factory has a productive life of 20 years. At the end of 20 years, its value will be zero. For each of these 20 years, the company will have to estimate how much cash inflows it expects from the factory.
The discount rate at which the present value of all the future cash inflows is equal to the capital expenditure on this factory is called the internal rate of return. To calculate this, we do not need any external factor like cost of capital or inflation. All we need is the estimated cash inflows and outflows. Hence, it is called “internal.”
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The Formula for the Internal Rate of Return (IRR): The internal rate of return can be calculated by using the following formula:
0 = CF0 + [CF1/(1+IRR)] + [CF2/(1+IRR)2] + [CF3/(1+IRR)3] +……..+ [CFn/(1+IRR)n]
In this formula, CF0 stands for the initial investment in a project. CF1, CF2, CF3….. CFn stand for cash flows in the future years. N stands for the duration of a project.
Example of the Internal Rate of Return’s Calculation Using a Spreadsheet: Let us consider the project below. It has a capital outlay in Year 0 (today). Hence, the cash flows in Year 0 are shown as negative. However, from Year 1 to Year 10, it has cash inflows. All these numbers are entered into a spreadsheet. Let us say that the IRR is 5%. The present value column shows the discounted value of future cash inflows. At 5% IRR, the NPV is ₹8,191. However, we know that the IRR is the rate at which the NPV of a project is 0. Hence, we can use the Goal Seek function of MS Excel to find out the IRR at which the NPV is 0.
IRR | 5.00% | |
Cash flows | Present Value | |
Year 0 | -1,00,000 | -1,00,000 |
Year 1 | 10,000 | 9,524 |
Year 2 | 15,000 | 13,605 |
Year 3 | 15,000 | 12,958 |
Year 4 | 20,000 | 16,454 |
Year 5 | 20,000 | 15,671 |
Year 6 | 15,000 | 11,193 |
Year 7 | 15,000 | 10,660 |
Year 8 | 10,000 | 6,768 |
Year 9 | 10,000 | 6,446 |
Year 10 | 8,000 | 4,911 |
Net Present Value (NPV) | 8,191 |
When we use the Goal Seek function, we will notice that the IRR is 6.74%, as shown below.
IRR | 6.74% | |
Cash flows | Present Value | |
Year 0 | -1,00,000 | -1,00,000 |
Year 1 | 10,000 | 9,368 |
Year 2 | 15,000 | 13,165 |
Year 3 | 15,000 | 12,333 |
Year 4 | 20,000 | 15,405 |
Year 5 | 20,000 | 14,432 |
Year 6 | 15,000 | 10,140 |
Year 7 | 15,000 | 9,500 |
Year 8 | 10,000 | 5,933 |
Year 9 | 10,000 | 5,558 |
Year 10 | 8,000 | 4,166 |
Net Present Value (NPV) | 0 |
Examples of the Internal Rate of Return (IRR) Rule in Investment Decisions
Suppose a company wants to invest in one project of the two options it has: Project A and Project B. The cash outflows and inflows are mentioned in the table below. Both projects have exactly the same initial capital expenditure and duration. Hence, they are comparable. Using the Goal Seek function of MS Excel, we can calculate their respective internal rate of returns, which are as follows:
IRR | 14.54% | 12.20% | ||
Project A's Cash Flows | Present Value | Project B's Cash Flows | Present Value | |
Year 0 | -50,000 | -50,000 | -50,000 | -50,000 |
Year 1 | 15,000 | 13,096 | 16,000 | 14,260 |
Year 2 | 20,000 | 15,246 | 18,000 | 14,299 |
Year 3 | 20,000 | 13,311 | 18,000 | 12,744 |
Year 4 | 10,000 | 5,811 | 12,000 | 7,572 |
Year 5 | 5,000 | 2,537 | 2,000 | 1,125 |
Net Present Value (NPV) | 0 | 0 |
As we can see that Project A’s IRR is higher than that of Project B, the company should select Project B.
The internal rate of return helps investors assess which project to invest in. Let us say that a company has to decide whether to invest in Project X or Project Y. It can compare the IRR of these two projects and invest in the project with a higher IRR. Besides, often companies do not have sufficient financing to invest in all projects. In such a situation, they can compare the IRR of various projects and decide which projects are worth pursuing.
The internal rate of return also helps investors compare a project’s actual IRR with its projected IRR. If the actual rate is higher than the projected rate, it is a good sign. However, if the actual rate is lower than the projected rate, then investors need to analyse why this is the case.
Once they have identified the reasons for a lower than expected IRR, they can take corrective action.
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Benefits of the Internal Rate of Return
The main benefits of internal rate of return are explained below:
Consider the time value of money: Several financial metrics, like payback period, do not consider the time value of money. However, the internal rate of return considers the time value of money. The fact is that the value of money deteriorates over time due to factors like inflation. Hence, by considering the time value of money, IRR provides investors with a realistic picture of a project.
Based on cash flows: IRR is based on cash flows. However, many other indicators use net profit, which is an accrual concept. While calculating net profit, a business considers all those incomes that it should have received and not those that it actually received. Similarly, it considers all the expenses that it ought to have paid and not the expenses it actually paid. However, cash flows are based on the actual cash inflows and outflows of a business. Hence, IRR is a better indicator.
Easy to interpret: As IRR is expressed in terms of a percentage, it is easy to understand and interpret. If a company has to decide whether to invest in a project, it has to check whether its IRR is higher or lower than a comparable project.
While the internal rate of return has its advantages, it has certain limitations as well, which are explained below:
Should not be used alone: When IRR is used alone, it can result in misleading conclusions. Let us say that Project A has 12% IRR and Project B has 15% IRR. It seems that Project B is better than Project A. However, Project A is for 20 years, while Project B is for only 5 years. As the duration of these projects is considerably different, IRR alone will not help an investor make a decision.
Does not consider the relative size of an investment: Let us take the same example. Suppose Project A and B have the same duration. However, Project A requires an investment of ₹100 crores, while Project B needs an outlay of ₹10 crores. As the respective outlay on the projects are vastly different, the net returns they will generate in absolute terms are also considerably different. Hence, IRR will not help us make a decision
Application of IRR in Stock Market Investments: The internal rate of return can be applied effectively while making stock market investments. Suppose a stock is trading at ₹100 today, you can calculate its IRR by estimating future cash flows from it, like dividends and its selling price. If you think its IRR is sufficiently high, you can invest in it, else you can avoid it.
How Traders Use IRR to Analyze Stocks: Typically, traders buy stocks for a short period of time. Once they buy a stock, they have to estimate the price at which they will be comfortable selling it. By using the price they have bought a share and the price they would like to sell it at, they can estimate its IRR and make a decision accordingly.
If you have a trading account and buy and sell shares frequently, then you should understand how the internal rate of return works. As explained above, it is an easy measure to understand and interpret, which can help you make trading decisions. On the other hand, if you are a business owner or manager, even then IRR can be extremely useful in deciding which project to invest in. While IRR has many benefits, it has a few drawbacks, too. Hence, you should be careful of its limitations and use it appropriately to get the best out of it.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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IRR is the rate at which the net present value of an investment is zero. It is calculated by using this formula:
0 = CF0 + [CF1/(1+IRR)] + [CF2/(1+IRR)2] + [CF3/(1+IRR)3] +……..+ [CFn/(1+IRR)n]
Suppose a company has multiple projects to choose from. It can decide which project to invest in using IRR. Typically, a project with a higher IRR is better than a project with a lower IRR. A company can also compare a project’s actual IRR with its estimated IRR to assess its performance.
IRR is the rate at which a project’s NPV is zero. However, NPV is the difference between the present value of a project’s cash inflows and the present value of its cash outflows.
The internal rate of return (IRR) does not consider the relative size of an investment and the duration of an investment. In case, two projects have significantly different capital expenditure or duration, then it becomes meaningless to compare their IRR
Yes, IRR can be used to evaluate stock market investments by calculating the cash outflows and inflows from such investments and then finding the discount rate at which their NPV is zero.
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