The internal rate of return (IRR) measures the return of a potential investment. The calculation excludes external factors such as inflation and the cost of capital, which is why it’s called internal. IRR, which is expressed as a percentage, helps investors and business managers compare the profitability of different investments or capital expenditures. All else equal, an investment with a higher IRR is preferable to one with a lower IRR.
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Why Internal Rate of Return Is Important
IRR helps investors estimate how profitable an investment is likely to be. For instance, an investment might be said to have 10% IRR. This indicates that an investment will produce a 10% annual rate of return over its life.
Specifically, IRR is a discount rate that, when applied to expected cash flows from an investment, produces a net present value (NPV) of zero.
Calculating the IRR for different investments can help investors decide which one to invest in. However, IRR has some limitations that require investors to use some judgment when picking investments.
NPV and IRR are related concepts and financial analysts use both. The difference is that IRR gives the yield on an investment (as a percentage), while NPV is the present value of the investment (in, say, dollars).
What Is IRR Used For?
Businesses use IRR to decide which projects or investments to fund. For instance, IRR could help a manager choose between upgrading equipment or increasing product development.
Businesses often set a minimum required rate of return for investments, called the hurdle rate. If a proposed project can’t produce an IRR higher than the hurdle rate, the proposal is dead in the water.
Similarly, a project’s IRR should exceed the cost of capital, or the interest charged on a loan taken out to fund the investment. An IRR less than the cost of capital will likely kill the project.
Investors can use IRR to calculate the expected return on a stock purchase. It can also help determine a bond’s yield to maturity. It can even help to balance risk and reward when buying real estate.
Venture capitalists and private equity investors use IRR to evaluate investments in companies. IRR suits scenarios involving a one-time investment of cash followed by one or more returns of cash over time.
How to Calculate IRR
You can calculate IRR by hand, but it is complex. It also is a trial-and-error method that only produces an approximate answer.
Spreadsheet software and business and finance calculators figure IRR much more accurately and easily. The trade-off is that doing the work by hand is more transparent.
Let’s say, for example, that a company is considering spending $100,000 for a piece of equipment with a three-year lifespan. The new item will increase production enough to boost cash flow by $25,000 the first year. Cash flow will also increase $50,000 the second year and $75,000 the final year.
After three years, in this case, the worn-out equipment has zero value. If it had some salvage or scrap value, the IRR formula could also account for that.
To calculate the IRR for that investment in a spreadsheet, first enter the the initial cost in one cell as a negative number. Next, enter each of the three years’ worth of cash flow increases as positive numbers in the three cells below. Finally, in another cell, use the IRR formula on the previous four cells showing the purchase’s cash flow. The IRR for the project will appear in that cell. Here’s how it would look:
- Initial investment: -$100,000
- First year return: $25,000
- Second year return: $50,000
- Third year return: $75,000
In this case the IRR is 19%. That is, this discount rate produces an NPV of zero given the initial investment and subsequent cash flows over the life of the equipment. Assuming the business’ capital costs are less than 19%, this could be a good investment. If you’re comparing investments, that 19% would need to beat the IRR on competing investments.
The Limitations of IRR
What is IRR in the grander sense? Just one of many metrics businesses and investors use to parse investment choices. One potential limitation with IRR is that it may favor small investments over larger ones. It may also make investments with small, short-term returns appear to be preferable to those with bigger, long-term returns. This could lead an investor to miss out on more profitable ventures.
For example, a $100 investment that returns $300 in a year has a more favorable IRR than a $10,000 investment that returns $20,000 in a year. Yet the $10,000 investment would have much greater positive effect on the investor’s worth.
To cope with the limitations of IRR, investors also look at NPV. The two together will help identify investments with more impact on wealth in addition to higher rates of return.
Bottom Line
IRR can help you figure out just how much of a return on investment you’ll receive. It can also help you figure out which investments will perform better than others.
That said, IRR isn’t infallible. It doesn’t consider the total amount of return, only the rate of that return. While IRR can still be a useful financial tool, you may want to consider using it along with several other calculations before making an investment.
Investing Tips
- If you don’t think IRR is giving you the full picture of a particular investment, you may want to consult a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Yes, SmartAsset’s investment calculator can help you determine your rate of return, but it shouldn’t be the only tool you use. Consider using SmartAsset’s asset allocation calculator to determine your risk tolerance, or SmartAsset’s inflation calculator to see how much your returns will be worth over time.
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