IRR – Definition, Uses, How to Calculate, and More

IRR (Internal Rate of Return) is a common metric used to understand the profitability and earnings of a particular investment. It factors in the time value of money to estimate profits.

If the IRR on investment increases, it becomes more lucrative for investors. To know more about IRR, read on.

IRR meaning

The IRR’s full form is – the internal rate of return. The IRR is a kind of discount rate that makes an investment’s net present value or NPV zero. The IRR defines the compounded return that an investor will earn on the investment in the near future. It is commonly used to analyse the financial performance of an investment.

Let’s take an example to understand it better. The chemical company SRF had a free cash flow to equity of Rs. 269 cr. in FY 2018. In other words, after accounting for capital expenditures and other cash inflows and outflows, the company generated a net cash flow to shareholders of Rs. 269 cr. The cash flow for FY 2019 was Rs. 629 cr.; for FY 2020 was Rs. 450 cr., and so on – as shown in the table below.  

Let’s also assume that the terminal cash flow (or the cash flow that the investor expects the company to generate in perpetuity) is Rs. 83,119 cr. If an investor had bought SRF’s share on 31st March 2017 when its price was Rs. 325 (and a market cap of approx. Rs. 9,730 cr.), here’s how the cash flow table would look (the initial investment is negative because when the investor invests, it is a cash outflow):

		XIRR (Extended Internal Rate of Return) (Rs. in cr.)
31.03.2017	Initial investment	-9,730
31.03.2018	Cash flow 1	269.12
31.03.2019	Cash flow 2	629.45
31.03.2020	Cash flow 3	450.47
31.03.2021	Cash flow 4	-334.26
31.03.2022	Terminal value	83,119.5
		55.2%

Note that we are also assuming that the cash flows occur at the end of the respective years. Given this series of cash flows, the internal rate of return (which is XIRR in Excel) comes to 55.2%.

In other words, an investment in SRF made on 31st March 2017 could have generated a compounded annual rate of return (or internal rate of return) of 55.2% for the investor. Not bad, right?

How to calculate IRR?

The IRR calculation formula is quite complicated. You can calculate the IRR as follows:

​0 = NPV = t=1∑T (​C_t/(1+IRR)^t ​​)−C₀

Here:

C_t = Net cash inflow during the period t

C₀ = Total initial investment costs

IRR = The internal rate of return

T= The number of time periods

• The IRR helps analyse the performance of investments. 
• Using IRR, you can estimate the profitability of a project where you have made investments.
• IRR plays a vital role in capital budgeting. Hence, you should know how to calculate it.

Return on investment vs internal rate of return: What’s the difference?

Some people might use the terms ROI and IRR interchangeably. However, both terms are quite different from one another. Let’s try to understand the difference between the two concepts.

Internal rate of return (IRR)	Return on investments (ROI)
IRR represents the discounted rate at which a project or investment’s future cash flows are estimated.	ROI shows the percentage of growth or reduction in the value of the investment from its initial cost.
IRR is solely used to measure the cash flows that an investment might generate in the future.	ROI shows how much the investment has grown since the day of investment.
IRR is a commonly used metric by financial analysts, hired to check the viability of a project and estimate the expected cash flow.	ROI is used by everyday investors to get an idea of the returns they will earn at the end of the investment period.
The calculation of IRR is quite complex as it involves net cash inflow during the period of investment.	ROI is easy to calculate.

While the ROI measures the overall profitability of an investment, the IRR tries to capture the estimated future cash flows from an investment.

Moreover, just like ROI, CAGR and IRR is used interchangeably by some people evaluate the investment’s performance. However, there is a key difference.

The key difference between the standard CAGR (or compounded annual growth of return) and IRR is that the former does not account for the timing of cash flows, while the latter does. In other words, if the cash flow occurs in the middle of the year (in our example, it occurs at the end of the year), then the IRR accounts for this mid-year compounding. It also accounts for any negative cash flows in between. In contrast, the CAGR only considers the initial cash flow and the ending cash flow.

CAGR vs IRR

CAGR stands for Compounded Annual Growth Rate. While both concepts help evaluate the investment’s performance, they highlight quite different aspects of a particular investment. Let’s have a look at the difference between IRR and CAGR.

IRR	CAGR
To calculate the IRR, you calculate the cash flow of the project using the values of the initial investment and the time period.	CAGR is calculated with the help of an investment’s starting and ending value and the number of investment periods.
IRR considers the periodic cash flows of the investments to understand the present value of the future cash flows of an investment.	CAGR does not factor in any periodic investments. It only considers the initial and the final amount.
IRR is widely used to evaluate projects as it considers the negative and positive cash flows during the investment period.	CAGR is not a widely used metric as it ignores the dip in the value during the investment period.

Therefore, IRR may be ideal for analysing the viability and the return on investment in comparison to CAGR. 

Difference between NPV and IRR 

Both IRR and NPV (Net Present Value) are important financial metrics. However, they have different calculation methods and represent different aspects of an investment. Some other differences between the two concepts are

IRR	NPV
The IRR is calculated in percentage.	The NPV depicts the cash value.
The IRR is a relative measure of financial performance.	The NPV is an absolute measure of financial performance.
The IRR frequently changes. Hence, it is a less effective metric for evaluating financial performance.	The NPV is a stable method of understanding the financial performance of an investment.
IRR does not consider any additional wealth during the calculation.	NPV considers additional wealth during calculation.

Investors prefer using IRR to evaluate the performance of short-term projects, while NPV is a better metric to analyse and estimate the performance of long-term projects.

IRR in capital budgeting

IRR is a commonly used capital budgeting technique. It can be a deciding factor when it comes to choosing investments. For instance, if the cost of two projects is the same, the one with a better IRR may be ideal. 

Importance of IRR

Several companies use IRR to understand the financial implications of an investment. Some other popular uses of an IRR are:

• IRR is used to compare the profitability of two or more investments. Hence, it is an important tool for planning.
• Several companies use IRR to understand the stock buyback programs before offering them to their employees.
• Even individual investors use IRR to compare the returns on different insurance policies.

Disadvantages of IRR

While IRR is a widely used metric used to understand the performance of an investment, it has some shortcomings, too, as stated below.

• IRR does not consider the project’s duration while evaluating the performance.
• Instead of accounting for the cost of capital, IRR presumes that cash flows are reinvested at the same rate as the project. As a result, IRR might not accurately reflect profitability.

Conclusion

IRR is a crucial financial metric. It is widely used to understand the financial viability of a project or an investment. As an investor, you must know how to predict the present value of future cash flows using IRR. Once you know the concept, you can use the tool to compare investments effectively.

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