Internal Rate of Return (IRR) – Meaning, Calculation & Advantages

 In the world of finance and investments, very often you hear the term IRR or internal rate of return. Many a time, company officials make announcements of going ahead with a project because it is financially viable. A company uses a variety of financial tools and metrics to evaluate the commercial attractiveness of a project to make its operating and investing decision. One of such vital parameters to determine the attractiveness of the project and whether or not a company should invest its resources in it is by calculating the internal rate of return, or IRR of the project.  

What is the Internal Rate of Return (IRR)?

Internal rate of return (IRR) is a capital budgeting technique to gauge the performance of an investment and the help determine its profitability. IRR is expressed as a percentage, and it is the discount rate at which the net present value of an investment or project becomes zero. IRR takes into account the time value of money and capital inflows and outflows over the life of the investment. As the full form of IRR suggests, it is the internal rate of return and does not take into account external factors like inflation, state of the economy, etc. at the time of calculating returns.

In simple terms, IRR is the breakeven rate of a project. If the IRR of a project is high and exceeds the required rate of return, then the company will go ahead and invest in the project, but if the IRR is low and below the required rate of return, then the company will not go ahead with it. It also helps analyze and compare between different projects and how to prioritize projects based on their IRR.

How is IRR calculated?

Calculating the IRR of a project is not a straightforward calculation. It requires trial and error as we try to arrive at a percentage wherein the net present value of the investment will become zero.  IRR of a project can be easily calculated through financial calculators or using the IRR function in excel.

The formula for IRR is

   0= P0 P1(1 IRR) P2/(1 RR)2 P3/(1 IRR)3 P4/(1 IRR)4 ...   Pn/(1 IRR)n

Where P0, P1 ... Pn are the cash flows in the period 1, 2, .., n, respectively and IRR is the internal rate of return of the investment.

Here is an example to show how to calculate IRR-

A company is considering the purchase of machinery to increase its sales, whose cost is Rs 3,00,000. This new machinery has a life of three years, and it will help the company generate an additional profit of Rs 1,50,000 per annum in the three years, and the scrap value, in the end,  is Rs 10000. The company’s rate of return from investing the cash in other investments will fetch a return of 15%. Now, if we want to find out if buying the machinery is a better option or not, we have to calculate IRR. 

0 = -Rs 300,000 (Rs150, 000)/(1 .243) (Rs150,000)/(1 .2431)2  (Rs 150,000)/(1 .2431)3  Rs10,000/(1 .2431)4

The net present value of the investment becomes zero when the IRR assumed is 24.31% which is much higher than the required rate of return of 15%. Thus, the company must purchase the machinery.
 

What are the advantages of using IRR in investments?

There are many advantages of using IRR technique at the time of analyzing investments and include-

• Time Value of Money is considered

One of the significant benefits of using the IRR technique is that it takes into account the time value of money at the time of calculating the returns from an investment.  This makes IRR credible and accurate to determine the future earning potential of the money

• A simple technique for analysis

Using the IRR technique to assess the profitability of the project is straightforward. If the project IRR is higher than the cost of capital or required rate of return, then it is advisable to go ahead otherwise not.

• Helps rank and compare projects from an investment perspective

When you have to make a comparison between two or more projects, IRR is useful in comparing and ranking projects depending on the yield. The project with a higher IRR is preferred.

Limitations of IRR technique

Even though IRR is an important financial metric in capital budgeting, it has its limitations. The major drawbacks of using IRR technique are-

• Project duration, size, etc. not considered

One of the most significant disadvantages of IRR is that it does not take into account important aspects such as the scale of the project, time taken for completion, etc. into account at the time of comparing projects, which can be misleading.

• The assumption about the reinvestment rate

Another limitation of using the IRR technique is that it assumes the same reinvestment rate for all the future cash flows throughout the tenure of the project, which is not practical as not all the future cash flows may have the same reinvestment opportunity.

One of the best ways to overcome the limitations of IRR is that one should not use IRR in isolation but use the NPV method and IRR together in capital budgeting to understand the profitability of the project.  Another option is to use the MIRR, which is the modified internal rate of return, which helps overcome the assumption of reinvestment at the same rate. 

Conclusion

IRR plays an important role in determining the return from your investments, and if you want to use IRR in practice, then open a Demat account with IndiaNivesh and get the correct guidance from our experts to get desirable returns on your investments.

 

Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
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