The internal rate of return (IRR) measures the return of a potential investment while excluding external factors. IRR helps investors estimate how profitable an investment is likely to be. All else equal, an investment with a higher IRR is preferable to an investment with a lower IRR. The following answers what is IRR, how it could influence your investments and what IRR limitations investors should consider.
What Is IRR and How Does It Work?
IRR helps investors estimate how profitable an investment is likely to be. Specifically, IRR is a discount rate that, when applied to expected cash flows from an investment, produces a net present value (NPV) of zero.
IRR is expressed as a percentage. For instance, an investment might be said to have 10% IRR. This indicates that an investment will produce a 10% annual rate of return over its life.
Calculating the IRR for different investments can help investors decide which one to invest in. However, IRR has some limitations that require investors to use some judgement when picking investments.
NPV and IRR are related concepts and investors use both. The difference is that IRR gives the yield on an investment. NPV helps shows how a given investment will affect overall wealth.
Uses of IRRWhat is IRR used for? Well, businesses use IRR to decide which projects or investments to fund. For instance, IRR could help choose between buying a new machine and investing in product development.
IRR is sensitive to the cost of capital, or the interest charged on a loan taken out to fund the investment. If an investment’s IRR is less than the cost of capital, it will be seen as a poor investment.
Businesses often set a minimum required rate of return for investments. If a proposal can’t produce an IRR higher than the minimum, it can kill a project.
Investors can use IRR to calculate the expected return on a stock purchase. It can also be used to figure a bond’s yield to maturity. It can even be used to balance risk and reward when buying real estate.
Venture capitalists and private equity investors use IRR to evaluate investments in companies. IRR suits scenarios involving a onetime investment of cash followed by one or more returns of cash over time.
Calculating IRRYou can calculate IRR by hand, but is complex. It also is a trial and error method that only produces an approximate answer.
Spreadsheet software and business and finance calculators figure IRR much more accurately and easily. The tradeoff is that doing the work by hand is more transparent.
Let’s say, for example, that a company is considering spending $100,000 for a piece of equipment with a threeyear lifespan. The new item will increase production enough to boost cash flow by $25,000 the first year. Cash flow will also increase $50,000 the second year and $75,000 the final year.
After three years, in this case, the wornout equipment has zero value. If it had some salvage or scrap value, the IRR formula could also account for that.
Tto calculate the IRR for that investment in a spreadsheet, first enter the the initial cost in one cell as a negative number. Next, enter each of the three years’ worth of cash flow increases as positive numbers in the three cells below.
Finally, in another cell, use the IRR formula on the previous four cells showing the purchase’s cash flow. The IRR for the project will appear in that cell.
Here’s how it would look:
Initial investment $100,000 First year return $25,000 Second year return $50,000 Third year return $75,000The IRR formula in the lowerright cell is: =IRR(B4:B7).
In this case the IRR is 19%. That is, this discount rate produces an NPV of zero given the initial investment and subsequent cash flows over the life of the equipment.
Assuming the business’s cost of capital is less than 19%, this could be a good investment. If you’re comparing investments, that 19% would need to beat the IRR on competing investments.
IRR LimitationsWhat is IRR in the grander sense? Just one of many metrics businesses and investors use to parse investment choices. One potential limitation with IRR is that it may favor small investments over larger ones. It may also make investments with small, shortterm returns appear to be preferable to those with bigger, longterm returns. This could lead an investor to miss out on more profitable ventures.
For example, a $100 investment that returns $300 in a year has a more favorable IRR than a $10,000 investment that returns $20,000 in a year. Yet the $10,000 investment would have much greater positive effect on the investor’s worth.
To cope with the limitations of IRR, investors also look at NPV. The two together will help identify investments with more impact on wealth in addition to higher rates of return.
Bottom LineIRR can help you figure out just how much of a return on investment you’ll receive. It can also help you figure out which investments will perform better than others.
That said, IRR isn’t infallible. It doesn’t consider the total amount of return, only the rate of that return. While IRR can still be a useful financial tool, you may want to consider using it along with several other calculations before making an investment.
Investment TipsPhoto credit: iStock.com/LIgorko, iStock.com/Ridofranz, iStock.com/danielvfung
The post What Is Internal Rate of Return (IRR)? appeared first on SmartAsset Blog.
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