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What is IRR & how to calculate it?

India Infoline News Service | Mumbai |

The internal rate of return is usually used to calculate the profitability of investments made in a financial product or projects

You invest a certain amount every year in some financial instruments like mutual funds, ULIPs, etc. After five, 10 years or 15 years, you may want to redeem your investments. At that time, we usually calculate the money which we originally invested with the maturity amount that we received to understand how much did we gain. But do you think this is the right method to check how much did we gain? We need to know how much return we got on our investments. This requires some basic calculations. Lets try to understand the concept of IRR or internal rate of return.


What is NPV?

Its impossible to understand the concept of IRR without understanding net present value (NPV), so lets begin with NPV. The cash that we have today is more valuable than the cash that we will receive after five years due to inflation. Hence, when you decide to invest money each year, you need to first check how much that money is worth today. This is called net present value of money.


Assume your friend tells you about a project A in which you invest Rs. 10 lakh today and from next year  the project will start generating cash flows without any further investment. The below table provides information on the money invested today and the cash flows generated in future.


Number of years & cash flows
PeriodProject A
TodayRs. -10 lakh
Year 1Rs. 2 lakh
Year 2Rs. 3 lakh
Year 3Rs. 3 lakh
Year 4Rs. 3.5 lakh
Year 5Rs. 3.5 lakh
Total of cash flowsRs. 15 lakh

You surely want to know whether project A is worth investing, than depositing money with banks. To compare benefits, you need to find out the net present value (NPV) of these cash flows. Assume IRR is around 8% for project A. IRR is also called discount rate. To calculate NPV of this project, discount each cash flow with IRR keeping in mind the time lapse. The formula to compute NPV is cash flow / discount rate + 1^N. The term N stands for the number of years


Compute NPV
PeriodProject A Discount rate NPV* (Rs)
TodayRs. -10 lakh 8%(10 lakh)
Year 1Rs. 2 lakh8%1,85,185
Year 2Rs. 3 lakh8%2,57,202
Year 3Rs. 3 lakh8%2,38,150
Year 4Rs. 3.5 lakh8%2,57,260
Year 5Rs. 3.5 lakh8%2,38,204
Total of cash flows11,76,001

NPV = Cash flow / discount rate + 1^N

The above table shows that project A has an NPV of Rs. 11.76 lakh, while you are investing Rs. 10 lakh today. This shows that the project A is not worth investing as the value of its cash flows today is Rs. 11.76 lakhwhich is Rs. 1.76 lakh extra than what you are investing today (Rs. 10 lakh). NPV should always be more than zero i.e. the project is giving us more returns than the money invested today.


What is IRR?


Internal rate of return or IRR is that rate of return at which NPV from the above investment & cash flows will become zero. IRR is the rate of interest that makes the sum of all cash flows zero, and is useful to compare one investment to another.


In the above example, if we replace 8% with 13.92%, NPV will become zero, and thats your IRR. Therefore, IRR is defined as the discount rate at which the NPV of a project becomes zero.


How to evaluate NPV
PeriodProject A Discount rateNPV (Rs)
TodayRs. -10 lakh 13.92%(10 lakh)
Year 1Rs. 2 lakh13.92%1,75,569
Year 2Rs. 3 lakh13.92%2,31,184
Year 3Rs. 3 lakh13.92%2,02,944
Year 4Rs. 3.5 lakh13.92%2,07,846
Year 5Rs. 3.5 lakh13.92%1,82,457
Total of cash flows10 lakh

How to calculate IRR?

To understand why 13.92% is taken as the interest rate, we need to find the IRR. In an Excel sheet, first enter the original amount invested. The amount invested should be represented by a minus sign. In each cell enter the cash flows which received each year. Remember to include the minus sign whenever you invest money. Now find out IRR by mentioning =IRR(values,guess).


Compute IRR on Excel 
No. of yearsProject A
Today-1000000
Year 1200000
Year 2300000
Year 3300000
Year 4350000
Year 5350000
IRR14%

IRR is the interest rate received for an investment consisting of money invested (negative value) and cash flows (positive value) that occur at regular periods.


Please note

  • The numbers included should be a set of positive and negative values

  • The last value is the amount you receive

  • Any amount invested will be negative so if you invest Rs. 1,000, mention -1000

  • The amount which you get at the end will be positive. If you get Rs. 5,000, mention +5000

  • All investments made are done at regular intervals. For instance: investments are made on the 1st or 15th of every year

  • All the payments are assumed to be made annually.

IRR is usually used to calculate the profitability of investments made in a financial product or projects. Higher the IRR, the more profitable it is to invest in a financial scheme or project. Assume all financial products require the same amount of up-front investment, the product with the highest IRR would be considered the best. Of course, one also needs to understand the risk factors before investing.









 

 
 
 
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