Internal Rate of Return (IRR)

What is Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) is a type of metric used to measure the expected return on an investment. It is expressed as a percentage and is calculated by taking the net present value (NPV) of all the investments cash flows and dividing it by the original investment amount.

It is used to evaluate various investments, to compare different investments and to decide which is the best investment option. IRR gives us an idea of the return we should expect to make from our investments over a certain period.

How to calulate Internal Rate of Return (IRR)?

The formula for IRR is as follows:

IRR = Initial Investment − (NPV of Cash Flows / Series of Equal Payments)

Calculating IRR is relatively straightforward. To start with you should define the cash flows that form part of the investment. The cash flows should include both the investment made initially and all subsequent cash flows that are expected to arise (e.g. dividends, capital gains, liquidity received).

The cash flows should then be standardized, as this will enable the further calculation of the IRR in a uniform manner. This can be achieved by converting all the cash flows into today's dollars.

The standard cash flows can then be added together along with the initial investment to form a series of equal payments. The series of payments is then solved for the interest rate that gives the same value for the present value increasing annuities as the initial investment made.

For example, if an initial investment of one hundred dollars is made and the series of equal payments is twenty dollars for ten time periods, the IRR would be equal to 11%. This is because this series of payments would be equivalent to the NPV of the investment if an interest rate of 11% was applied.

What is a good Internal Rate of Return (IRR)?

A good IRR can vary greatly depending on the investment, the time horizon over which the investment is made and the investor's expectations. As a general rule, most investors strive for an IRR of at least 10%. This is because any IRR below this is likely to result in a relatively low amount of returns.

Having said that, a higher IRR is always more desirable. Some investments may be expected to have returns of anywhere between 12 to 25%, depending on the level of risk associated with the investment and the investor's expectations. Ultimately, the higher the IRR the better, however, investors should always assess this against the level of risk associated with the investment.

Difference between Internal Rate of Return (IRR) and Return on Equity (ROE)

Internal Rate of Return (IRR) and Return on Equity (ROE) are two different metrics used to measure performance.

IRR is a measure of the return that can be expected from an investment expressed as a percentage, given the series of cash flows associated with it. ROE on the other hand is a measure of the profitability of a company that is expressed as a percentage of the company's shareholder equity.

While both metrics measure financial performance, the two differ in terms of what they measure. Generally, ROE is used to assess the overall performance of a company while IRR is used to evaluate investments specifically.

What Does a Low Internal Rate of Return (IRR) Mean?

A low Internal Rate of Return (IRR) means the investment will not give a satisfactory return. Typically, if the IRR is less than the required rate of return, the investment should be avoided as it is not meeting the project's stated objectives.

A low IRR also indicates that the investment poses a certain amount of risk. Investors should consider the risk associated with the investment as well as the IRR before investing.

Difference between Internal Rate of Return (IRR) and Net Present Value (NPV)

Internal Rate of Return (IRR) and Net Present Value (NPV) are both metrics used to measure the expected return of investments.

IRR is a metric used to measure the return on an investment, whereas NPV is used to measure the overall present value of the same investment. The IRR takes into account all the periodic cash flows associated with an investment and calculates the rate of return over time. NPV on the other hand takes into account the present value of all those cash flows and calculates the return at a single point in time.

Ultimately, IRR is used to compare different investments, whereas NPV is used to measure the value of a single investment.