Steps in Calculating Internal Rate of Return (IRR)

by Sarath | October 24, 2023 | Internal Rate of Return , IRR

The internal rate of return (IRR) is a formula for estimating the rate of return on investment. The computation does not take into account external variables like the risk-free rate, inflation, the cost of capital, or financial risk, hence the name is “internal”. Ex-post or ex-ante applications of the approach are both possible. The IRR is a projection of a potential future annual rate of return when used ex-ante. It evaluates the real investment return of a past investment when applied ex-post. It is also known as the yield rate or the discounted cash flow rate of return (DCFROR). From this article, we can interpret the steps in calculating the internal rate of return.

Internal Rate of Return (IRR)

IRR is one of the capital investment evaluation techniques used by investors while making investment decisions. Using discounting techniques, the cash flows are reduced to their present value while taking the time value of money into the account. IRR is a type of discounting technique that is widely used by investors.

What is the Internal Rate of Return (IRR)?

The discount rate that compares the present value of the anticipated cash inflows with the initial cash outflow is the internal rate of return for an investment plan. The annualized effective compounded return rate that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero is the internal rate of return on an investment or project. In other words, it is the interest rate at which the total present value of costs (negative cash flows) equals the total present value of benefits, and at which the net present value of future cash flows equals the initial investment (positive cash flows). The time preference of money and investments are taken into consideration by IRR.

Uses of IRR

The internal rate of return makes the project attractive since the cash outflows and the present value of the inflows are equal. The uses of this rate are enumerated as follows:

The IRR acts as the effective interest rate for savings and loan calculations.
The profitability, effectiveness, quality, or yield of an investment is indicated by the internal rate of return.
An investment should only be made if its profitability, as determined by the internal rate of return, is higher than a minimum acceptable rate of return to maximize the value of a corporation. Hence this rate is a crucial factor in investment decisions.
Businesses utilize IRR in capital budgeting to contrast the profitability of various capital projects.
Investments in fixed-income securities are assessed using this rate.
It is a tool used by corporations to assess share issuance and stock buyback plans.
From the limited partners’ perspective, IRR is also utilized in private equity as a way to gauge how well the general partner is managing investments.

Importance of IRR

Businesses utilize a wide range of financial data and analysis tools to decide what to invest in and how to operate. The internal rate of return is one of these instruments. The IRR evaluates the long-term performance of a project, capital expenditure, or investment. Its significance is enumerated as follows

It enables businesses to assess the viability of a project or compare investments to one another.
Prudent investors make investment decisions only after determining the IRR of the project.
This metric can help you determine whether you spent your time and money wisely.
Calculating IRR assists not only in determining a worthwhile investment or endeavor but also helps you in deciding whether or not you should concentrate your efforts on a new project.
Knowing your company’s IRR will help you determine whether a project was profitable or not.
It also enables you to calculate the risk associated with investing in addition to its rate of return.

Limitations of IRR

The internal rate of return, unlike net present value, does not provide you with the return on your initial investment in actual money. For instance, knowing an IRR of 30% by itself does not indicate whether it is 30% of $10,000 or $1.0 million. Making investment decisions only based on IRR might be risky, especially when comparing two projects with different durations. Consider a scenario in which a company’s cost of capital is 12%, project A has a one-year IRR of 25%, whereas project B has a five-year IRR of 15%. If IRR is the only factor taken into consideration, project A will be erroneously chosen above project B.

The internal rate of return also makes the crucial assumption that any positive cash flows from a project will be reinvested at the same rate as the project, as opposed to the firm’s cost of capital. The profitability and expense of a project may therefore not be accurately reflected by the internal rate of return. To arrive at a more precise measurement, a wise financial analyst will instead employ the modified internal rate of return (MIRR).

Net IRR vs Gross IRR

The rate of return on an investment before fees and costs are called the gross IRR. The rate of return after deducting any fees or expenditures is known as the net IRR. The Gross IRR will always be greater than the Net IRR. In simple terms, Gross Returns refer to the returns at the fund level, whereas Net IRR refers to the returns to outside investors who have invested in the fund. These costs are associated with management fees, fund expenses, and carried interest when utilized in the context of private equity. LPs generally employ Gross IRR and Net IRR to make capital allocation decisions. This might apply to several asset sectors, such as real estate, private equity, and public markets. Or, it might be between funds in a certain asset class.

Consider two private equity businesses that are raising fresh capital. To obtain financial commitments, they approach LPs and market the possible investment based on the success of their former and current funds. Firm A’s historical Gross IRR is 25%, while Firm B’s is 20%. Firm A appears to be the superior investment option at first glance. However, looking at the historical Net IRRs for the two firms reveals that Firm A is at 15% and Firm B is at 18%. In this case, you would choose to give Firm B your financial support.

In that case, it stands to reason that private equity LPs (limited partners) are primarily concerned with Net IRR. Because of this, they will earn returns from the fund. On the other hand, you are probably more interested in Gross IRR if you are comparing employment offers from various private equity firms. The difference between Gross IRR and Net IRR indicates the economic share for that firm and fund, and it provides a clear representation of actual investment success.

How to calculate IRR?

The IRR is the estimated interest rate at which the initial capital investment must have increased to achieve the ending value from the beginning value given a specified range of dates. It is calculated by dividing the future value by the present value of an investment.

Formula of IRR

Its calculation takes into consideration two discount rates. A range of rates would be chosen as higher discount rates and lower discount rates. For example, IRR will be calculated between 13% and 15%. Here 13% is the lower discount rate and 15% is the higher discount rate. The interpolation formula for IRR is illustrated as follows

IRR = lower discount rate + (Net present value at the lower discount rate/Net present value at higher discount rate)*(higher discount rate – lower discount rate)

Net present value involves discounting future cash flows at the current discount rate.

Steps in calculating IRR

The method for calculating IRR varies depending on the pattern of net cash flows over an investment’s useful life. The steps for manually calculating the IRR metric are as follows.

Select two estimated discount rates

The interpolation formula of IRR involves two discount rates. So a range of rates could be chosen with a lower discount rate and a higher discount rate. The gap between the two estimated discount rates should be reasonable. For instance, let’s assume the lower rate is 12% and the higher rate is 15%. The range of rates should be chosen reasonably without a higher difference between them.

Calculate the net present values

NPV is calculated with the help of this formula

NPV = Net cash flow at time/(1+discount rate)^t

Here t refers to the time of the cash flow.

Calculate the IRR

And finally, IRR is calculated by the interpolation formula. In simple terms, the future value of cash flows is divided by the present value of cash flows for the prescribed period.

How to calculate IRR in excel?

IRR is calculated using an iterative process in Microsoft Excel. It runs through the calculations starting with a guess until the result is accurate to within 0.00001%. The syntax for IRR calculation in excel is:

IRR (values,[guess])

To determine the internal rate of return, values must have at least one positive and one negative value.

How to use IRR with WACC?

The WACC measures the anticipated average future expenses of capital (from both debt and equity sources), and the IRR measures the effectiveness of an investment.

The weighted average cost of capital will rise in tandem with the company’s capitalization. The internal Rate of Return will drop when a company’s capital increases. The IRR is inversely correlated with the amount of capital because higher profits are required to raise the IRR.

IRR vs ROI

ROI implies that all cash flows will be collected at the end of the investment, whereas IRR takes into account the cash flows received throughout the investment at various points.
IRR is a measure that is highly significant to compute since it considers the future value of money. In contrast, ROI doesn’t consider the future value of money while making its estimates.
More precise estimates are required for IRR to precisely calculate the investment’s performance. On the other hand, ROI is rather straightforward, and once all the essential data is provided, it is simple to calculate ROI.

What is good IRR?

An excellent IRR would exceed the initial sum that a business has put into a project. Most private equity firms aim to achieve an IRR of 20% or more. But when we take a view on a sector-specific approach, a real estate entity aims for an IRR between 15% to 20%.Hence favorable IRR is dynamic for different industries. It fluctuates depending on several factors, including the cost basis, the market, the specific class, the investment strategy, and various other things.

Example of IRR

Assume paying $400,000 in cash to buy a piece of property. This represents a cash outflow. You anticipate making a profit of $25,000 per year by renting the apartment for $2,000 to $2,100 per month. This is regarded as an inflow of cash. IRR can be calculated manually by using the interpolation formula explained above or by using excel by providing valid syntax. By employing any of the above methods of calculation, we can predict a 1% rate of return in year 17 and so on.

Get a business valuation from Eqvista!

When there are many investment alternatives, the Internal Rate of Return is appropriate. This facilitates decision-making by allowing investors to rate their investment options from highest to lowest IRR. To make decisions regarding investments, the valuation of the business is crucial. Need help with your business valuation? Eqvista aids you with business valuation and filing. For more details visit our page. Feel free to contact us anytime!