What is IRR & how to calculate it?

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

October 22, 2012 4:11 IST | India Infoline News Service

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. Let’s try to understand the concept of IRR or internal rate of return.

What is NPV?

It’s impossible to understand the concept of IRR without understanding net present value (NPV), so let’s 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
Period Project A
Today Rs. -10 lakh
Year 1 Rs. 2 lakh
Year 2 Rs. 3 lakh
Year 3 Rs. 3 lakh
Year 4 Rs. 3.5 lakh
Year 5 Rs. 3.5 lakh
Total of cash flows Rs. 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
Period Project A Discount rate NPV* (Rs)
Today Rs. -10 lakh 8% (10 lakh)
Year 1 Rs. 2 lakh 8% 1,85,185
Year 2 Rs. 3 lakh 8% 2,57,202
Year 3 Rs. 3 lakh 8% 2,38,150
Year 4 Rs. 3.5 lakh 8% 2,57,260
Year 5 Rs. 3.5 lakh 8% 2,38,204
Total of cash flows 11,76,001

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 lakh—which 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 that’s your IRR. Therefore, IRR is defined as the discount rate at which the NPV of a project becomes zero.

How to evaluate NPV
Period Project A Discount rate NPV (Rs)
Today Rs. -10 lakh 13.92% (10 lakh)
Year 1 Rs. 2 lakh 13.92% 1,75,569
Year 2 Rs. 3 lakh 13.92% 2,31,184
Year 3 Rs. 3 lakh 13.92% 2,02,944
Year 4 Rs. 3.5 lakh 13.92% 2,07,846
Year 5 Rs. 3.5 lakh 13.92% 1,82,457
Total of cash flows 10 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 years Project A
Today -1000000
Year 1 200000
Year 2 300000
Year 3 300000
Year 4 350000
Year 5 350000
IRR 14%

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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