What is the Internal Rate of Return : Formula & Examples

Key Takeaways
 

• IRR tells you how much profit an investment can make each year.
   
• If the IRR is higher than what you expect, the investment is usually good.
   
• Businesses use IRR to decide which projects are worth investing in.

The Internal Rate of Return (IRR) is a key financial tool used to measure how profitable an investment or project might be. It tells you the annual return rate that makes the value of future earnings equal to the original investment.

Let’s look at a simple example. Imagine a business invests ₹1,00,000 in a project and receives ₹40,000 at the end of each year for 3 years. To judge whether the project is worth it, the investor calculates the IRR, the rate at which the Net Present Value (NPV) becomes zero.
 

Using a financial calculator or Excel, the IRR in this case is about 18%. If this return is above the expected or required rate, the project is considered profitable.

Imagine lending ₹100 to a friend who promises ₹40 each year for 3 years. The Internal Rate of Return (IRR) shows if the money you get back is worth the original investment. If the IRR is higher than what you expect elsewhere, it’s a good deal. Companies use IRR the same way to decide whether a project meets their required return, though they also consider other factors before investing.

This blog will guide you through how IRR works and why it matters in smart investment planning.

How Do We Calculate the Internal Rate of Return (IRR)?

The formula for IRR may look tricky at first, but it follows the same structure as the Net Present Value (NPV) formula. The key difference is this: when we find IRR, we set the NPV to zero.

But first, what is NPV?

NPV (Net Present Value) tells us how much an investment is worth in today’s money. It adds up all the future cash you expect to receive from a project and subtracts the money you have to invest. If the NPV is positive, the investment is considered good. If it’s negative, it means you may lose money.

Here’s how the formula looks:

0 = CF₀ + CF₁ / (1 + IRR) + CF₂ / (1 + IRR)² + … + CFn / (1 + IRR)ⁿ

Let’s break it down:

• CF₀ is the starting investment (always a negative number, because it’s money going out)
   
• CF₁, CF₂, ... CFn are the future cash inflows or outflows for each period
   
• IRR is what we are trying to find: the interest rate that makes everything balance
   
• n is the number of years or periods

Bonus Tip: You cannot solve this like a normal equation. Since IRR is buried inside the brackets, we need to test different values for IRR until the left side becomes zero. This method is called trial and error.

Because this can be time-consuming, most people use tools like Excel or a financial calculator to find IRR quickly and accurately.

So, while the formula may look like a maths puzzle, you don’t have to solve it by hand. Let the calculator or software do the heavy lifting, and you just focus on making sense of the results.

Understanding IRR Through a Real-Life Scenario

LLC Limited, a company, wants to choose between two projects:

• Project A: building a new warehouse
• Project B: fixing and expanding their current warehouse

Both projects need money to start and will bring money back over the next three years. The company uses the Internal Rate of Return (IRR) to decide which project is better.

Project A:- New Warehouse

• Investment needed now: ₹20,00,000
• Expected returns:
  • Year 1: ₹7,00,000
  • Year 2: ₹8,00,000
  • Year 3: ₹9,00,000

LLC tries a return rate of 5%, but the result is not helpful. They try again with a 9% return rate. This time, when they plug the numbers into the formula, the final result comes to zero.

This means the IRR for Project A is 9%.

Project B:- Renovate Current Warehouse

• Investment needed now: ₹15,00,000
• Expected returns:
  • Year 1: ₹5,00,000
  • Year 2: ₹6,50,000
  • Year 3: ₹7,00,000

At first, they try a return rate of 9%, and the result is a small positive number, not zero. Then they try 11%, and this time the result becomes zero.

So, the IRR for Project B is 11%.

Which Project Should They Pick?

Since Project B has a higher IRR (11%) than Project A (9%), it gives better returns for the money invested. So, LLC Limited should go ahead with Project B.

So, IRR helps the company see which project grows their money faster, and that makes it easier to choose the smarter option.

How is IRR interpreted?

The Internal Rate of Return (IRR) helps investors and businesses understand how profitable a project might be. Although it’s a useful tool, IRR is based on expected future cash flows, which means the actual profits may turn out to be different.

Still, analysts can draw helpful insights by comparing IRR with other figures, especially the Net Present Value (NPV).

Here’s how to interpret IRR in simple terms:
 

RR works best when used with NPV. Together, they help compare different projects fairly and make well-informed decisions.

Looking Beyond IRR: Understanding Its Limitations

The Internal Rate of Return (IRR) is a helpful tool to measure how quickly an investment might grow. However, like all financial tools, it has its flaws. Relying on IRR alone can sometimes lead to poor decisions. Here are some key limitations:
 

Because of these issues, analysts often prefer to use a more reliable version called the Modified Internal Rate of Return (MIRR). MIRR gives a clearer picture by assuming reinvestment happens at a realistic rate, not the IRR itself.

This ensures better comparison and more accurate project evaluation.

IRR vs Other Investment Metrics (NPV, ROI, Payback Period)

The Internal Rate of Return (IRR) is just one way to evaluate an investment, and it works best when compared with other metrics:

Net Present Value (NPV): NPV calculates the total value an investment adds in today’s terms, considering the time value of money. A positive NPV means the project is profitable. Unlike IRR, NPV shows the actual monetary gain, not just the percentage return.

Return on Investment (ROI): ROI measures the overall profit relative to the initial investment. It’s simple and useful for quick comparisons, but it ignores the timing of cash flows, which IRR accounts for.

Payback Period: This metric tells you how long it will take to recover the initial investment. While easy to understand, it doesn’t consider profits beyond the payback point or the time value of money, unlike IRR.

IRR gives the annual percentage return, but combining it with NPV, ROI, and payback period provides a fuller picture of an investment’s potential and risks.

Conclusion

The Internal Rate of Return (IRR) helps investors and businesses understand how quickly their money can grow through a project or investment. It shows the annual return rate that makes the value of future cash flows equal to the original cost.

When used correctly, IRR allows people to compare different projects and choose the one that offers the best growth. However, it works best when used alongside other tools like Net Present Value (NPV), especially when cash flows vary over time.

FAQ’s

1. What does IRR tell an investor?
IRR represents the annualised return rate at which the net present value of all future cash flows from an investment equals the initial capital outlay.

2. How can IRR help compare projects?
By quantifying the expected annual return, IRR allows investors to rank multiple projects and prioritise those likely to generate superior financial outcomes.

3. Is IRR the same as interest rate?
While both are expressed as percentages, IRR specifically measures the return on a particular investment over time, whereas an interest rate reflects the cost of borrowing or yield on savings.

4. Can small changes in cash flow affect IRR?
Indeed, minor variations in projected inflows or outflows can substantially alter the IRR, highlighting the sensitivity of this metric to cash flow assumptions.

5. Why do companies still check other metrics with IRR?
Because IRR alone does not capture total monetary gains, timing risks, or the scale of investment, integrating metrics like NPV or payback period provides a more comprehensive evaluation of viability.
 

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