IRR, ROI, XIRR, CAGR, TWRR, you must have come across many such acronyms in finance and investing. One common thread through all of them is that they are a rate or % value and each one finds application in different aspects of financial valuation.
However, bear in mind that they are all different from each other. We shall look at the IRR or Internal Rate of Return and a specific type i.e. the XIRR.
What is IRR?
Internal rate of return (IRR), technically speaking, is a rate at which the cash inflows would be equal to the cash outflows. Or in other words, the net cash flow would be zero.
This is similar to a parallel concept in economics called break-even point whereby the total sales equals the total fixed and variable costs. Thus profits are zero at a break-even point.
The emphasis on internal makes it evident that the calculation excludes external factors likes risk-free rate, the rate of inflation, the cost of capital and other financial risk metrics.
The main focal point in IRR analysis is the time factor. Thus before we attempt to understand IRR, let’s get a grasp of the time value of money.
Consider a simple example. Say you had two options- either receive Rs.1,00,000 now or receive Rs.1,00,000 after 6 months. The only difference between the two is the time aspect.
If you are aware of the concept of the time value of money, you would promptly choose option 1 i.e. give me the money right away!
This is because you could invest this money in the short term of 6 months and earn a tidy sum as interest income. Or, you could spend the money on a product for Rs.1 lakh, which might get a tad expensive i.e.over Rs.1 lakh if you were to buy the same product after 6 months.
How to Calculate IRR?
IRR is a discount rate at which the net present value of future cash flows is equal to the initial investment. Let’s consider an example.
Assume you invested Rs. 50,000 in a financial instrument. The expected annuity income is Rs.2000 for Year 1 and Rs 3000 for Year 2. The IRR computation would be as follows:
50000= 2000/(1+IRR)^1 +3000/(1+IRR)^2
Thus the future cash flows are converted to present terms i.e. time 0 or the time of the investment i.e. now to remove the impact of the time factor.
Formula of IRR
0= CF(0)+CF(1)/(1+IRR)^1 +CF(2)/(1+IRR)^2+…………CF(n)/(1+IRR)^n
NPV= CF(1)/(1+IRR)^1 +CF(2)/(1+IRR)^2+…………CF(n)/(1+IRR)^n
CF(0)= Initial investment amount
CF(1), CF(2),….CF(n)= periodic cash flows at future time periods
n = holding period
NPV= net present value
IRR=Internal rate of return
Ceteris Paribus or other things being equal, a return on investment obtained at a certain time is better than receiving the return at a later point of time. The former would yield a higher IRR than the latter.
Application of IRR
This is a very important concept in corporate finance as business firms are ultimately concerned with earning a rate of return on every investment that is higher than the cost of capital.
This can also be effectively applied in portfolio management whereby only those investment avenues that yield a high IRR can be accepted.
Consider an investment of Rs 10,000 that grows to Rs.11,000 at the end of the year. The yield is 10%. This would not be able to compute the impact of varying cash inflows or outflows during the year.
In conclusion, IRR is becoming a popular method of computing returns especially in portfolio management and mutual funds where there are several annuities involved with different time periods.
Disclaimer: The views expressed in this post are that of the author and not those of Groww