What is the Internal Rate of Return (IRR)? - Meaning, Formula and Usage

One of the most pivotal concepts in the world of finance is IRR, an acronym for Internal Rate of Return. It depicts the return on investment gained when a project finally recovers its expenses, indicating that the project's marginal value is only partially justified. 
 

To gain a complete understanding of what is the Internal Rate of Return, its types, components, and limitations, continue reading.

Internal Rate of Return Meaning

The Internal Rate of Return (IRR) is a financial measure used to estimate the amount of profits that can be generated by potential projects and investment plans. The purpose of IRR is to help you to understand the rate of return on the investment. 
 

There are at least two types of the Internal Rate of Return (IRR) for an investment: the project IRR and the equity IRR. 
 

The project IRR assumes that the cash flows directly contribute to the project's benefit, while equity IRR considers the returns for the company's shareholders once the debt obligations have been met.

How is the Internal Rate of Return (IRR) Calculated?

The amount of IRR is calculated with a similar concept as net present value (NPV), except that it sets the NPV equal to zero. You can find an abundance of Internal Rate of Return calculators online. However, the manual method comes with the Internal Rate of Return formula as given below:
 

Main Components of the IRR Calculation Formula

1. Net Present Value (NPV)

   Net present value (NPV) is a financial measure that aims to calculate the gross value of a project or investment opportunity. This is set to zero during the calculation of the rate of return (IRR) that recovers the expenses of the investment (when NPV equals zero).   

2. Cash Flow 

   Cash flows comprise the amount of money spent on or gained from an investment. This may include inflows of cash for profits, revenue, or outflows for expenses, such as interest or loan payments.

3. Number of Periods

   The length of the investment is determined by the number of periods. For example, a four-year project would have four time periods. These periods must be regular intervals such as monthly, quarterly or annually as the IRR is an average over all periods and is difficult to change to account for varying lengths of time. 

4. Initial Investment

   The initial investment signifies the expense necessary to initiate the project or investment. For instance, if you invest 20 lakhs in a new machine for a limited production of goods, it will serve as the initial investment that will be subtracted from the total discounted cash flows.

Use of the Internal Rate of Return: Understanding the IRR Rule

The IRR rule is mainly a technique that gives you an idea of whether to opt for a project or investment plan. The higher the estimated IRR on a project, the higher the cost of capital, and eventually, the more net cash a project can bring into the firm. 
 

So, if the project or investment is bound to make profits, the executives may plan to approve and put it into force. On the other hand, if the IRR is lower than the cost of capital, the rule believes that the best measure is to forgo or discard the project or investment.
 

Generally, the higher the Internal Rate of Interest, the better. But sometimes, a firm and its executives may also prefer an investment with a lower IRR if it comes with other intangible benefits. The reasons may include, for example, working towards a greater strategic goal or reducing competition in the market.

What are some Limitations to the Internal Rate of Return Method?

1. Sensitivity to Cash Flow Timing

   The IRR is highly sensitive to the timing of cash flows, which can potentially lead to misleading results. Sometimes, false results can emerge when employing IRR for the purpose of comparing projects with different durations.
    

   For instance, a short-term project may display a high IRR, building the illusion of a strong investment choice. On the other hand, a longer-term project may show a much lower IRR as the IRR rule ignores the project's true cost or any irregularities in the cash flow. 
    

2. False Errors Due to Shorter Holding Periods

   A holding period is the amount of time the project/investment is put on hold by an investor. Or, it is the period between the purchase and sale of an asset. 
    

   In cases where an investment has a short holding period, the calculated Internal Rate of Return may appear remarkably high. However, if this holding period were hypothetically extended, the estimated returns could become artificially unreasonable.

Wrapping Up

The Internal Rate of Return (IRR) is the rate of growth that a new project or investment is estimated to generate. The IRR rule states that you must only take on a new project if its IRR appears to exceed the initial expenses. Hence, the greater the IRR of your project, the higher the return on an investment. 
 

If you want to make the right investment choice, check out these Investment Plans that help you grow your wealth and manage your assets during financial crises.