What is IRR – Internal Rate of Return

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When you invest money, you always want to know how much it can grow. But many investments give you money or “returns” at different times. Now, how will you measure the yearly return in this case?

That’s where the Internal Rate of Return (IRR) is used. It tells you the annual return after considering the timing of each cash inflow and outflow. Read this article to learn the IRR meaning, formula, and how it differs from CAGR and XIRR (Extended Internal Rate of Return). 

 

What is the Internal Rate of Return?

Internal Rate of Return (IRR) is the rate of return a project or investment is expected to generate every year. It is the percentage at which:

• The present value of future cash inflows 

becomes “equal to”

• The initial investment or cash outflow

As an individual investor, you can use IRR to judge whether an investment is worth your money and time. It tells you the “annual return” you can expect from an investment, based on the cash you put in (investment) and the cash you expect to get back in the future (the returns).

For more clarity, let’s see how you can use IRR in different ways:

1. Compare Different Investment Options

If you have multiple choices, such as a fixed deposit, a mutual fund SIP, real estate, or bond investments, the internal rate of return allows you to compare them using a single number. Always remember that, 

• Higher IRR = higher annual return.

This knowledge allows you to select the option that grows your money faster.

2. Set Your Personal “Hurdle Rate”

Usually, the concept of IRR is used by companies, which compare it with a “hurdle rate”. As an individual investor, you can also do the same by setting your own hurdle rate. It could be:

• The return you can earn from a safe alternative (like a fixed deposit or government bond)

or

• The minimum return you expect for the risk you are taking
  

Now, if an investment’s IRR is above your hurdle rate, you may consider it. If it is below, you may reject it.

3. Evaluate Long-Term Investments With Irregular Cash Flows

Internal rate of return is also used when your cash inflows or returns do not occur at the same time. This happens when you invest a lump sum once and then receive money over several years.

For example, 

• Let’s say you invested ₹5,00,000 in 2020.
• After that, the project or investment returns money to you every year in varying amounts:
  • ₹1,20,000 in Year 1
  • ₹1,40,000 in Year 2
  • ₹1,80,000 in Year 3
  • ₹2,00,000 in Year 4
  • ₹2,20,000 in Year 5
• Note that these cash flows are irregular and occur at different points in time.
• Since each year’s cash inflow has a different timing and duration, you cannot use CAGR (Compounded Annual Growth Rate).
• Why? That’s because CAGR assumes a single cash inflow at the beginning and a single cash outflow at the end.
• In such cases, IRR becomes the correct return measure.
• IRR considers:
  • The exact timing of each annual cash inflow

and

• The total amount you receive over the entire period.
  

This gives you the true annual return on your 2020 investment, based on “how much money” you received each year and “when you received it”.

 

What is the IRR Formula?

To calculate the internal rate of return, you may use the following formula:

0 = CF0+ CF1(1 + IRR) +CF2(1 + IRR)2 + CF3(1 + IRR)3……………+ CFn(1 + IRR)n

Where:

• CF0 = Initial investment
• CF1, CF2, CF3, CFn = Future cash inflows or outflows
• n = Specific time period
• N = Total number of periods
• NPV = Net Present Value

This formula tells you that IRR is the discount rate that makes the Net Present Value (NPV) equal to zero. Let’s see how it happens:

1. Every Investment Has Cash Flows Over Time

• At the beginning, you spend money, which is represented by CF0.
• Later, you receive money depicted as CF1, CF2, CF3, CFn.

2. Money in the Future Is Worth Less Than Money Today

Now, considering the time value of money, each future cash flow is divided by (1+IRR)n.This “discounts” the future amounts back to today’s value. For example:

• A cash flow in Year 3 is divided by (1+IRR)3, because it occurs three years from now.

3. IRR is the Rate At Which The Total Present Value Becomes “Zero”

Now, the formula finds the rate at which the present value of all future cash inflows becomes exactly equal to the initial investment. At that rate:

• Present value of inflows = Initial investment
• This makes NPV (net present value) = 0

 

IRR vs CAGR: What’s the Difference?

CAGR (Compounded Annual Growth Rate) measures the “average annual growth rate” of an investment. It assumes:

• You invested all your money on one single day 

and

• Withdrew it on one single day (at some later point in time)

CAGR only works when there is one cash inflow (at the start) and one cash outflow (at the end). In contrast, IRR handles multiple cash flows, whether they are investments or returns, happening at different times. It calculates the actual annual return by considering the timing and amount of every cash flow. 

For more clarity, let’s check out the IRR vs CAGR detailed comparison:

How is IRR Used in Mutual Fund Investments?

When you invest in mutual funds via SIPs (Systematic Investment Plans), your money is invested in the market:

• On different dates 

and

• In different amounts

Now, again, because of this irregular timing, mutual fund returns cannot be measured with CAGR. Instead, the industry uses XIRR, which stands for “Extended Internal Rate of Return” and is a modified version of IRR. It is a method used to calculate your actual annual return when:

• You invest money on different dates
• The amounts vary
• You redeem units on different dates.

 

How Does XIRR Differ from IRR?

Internal rate of return works only when cash inflows (investments) or outflows (returns) are at fixed + equal time gaps. For example, you put money once a year and receive money once a year. The timing is predictable.

In contrast, XIRR is used when money moves on different dates, and the timing is uneven.
For example, in SIPs and SWP (systematic withdrawal plans), you invest or redeem on different days. This is why mutual funds use XIRR, not IRR. 

 

To Understand Better, Let’s Study an Example!

Assume you invest ₹5,000 every month through a SIP. Each ₹5,000 goes into the mutual fund on a different date. When you finally redeem the investment, the value you receive depends on the NAV at that time.

Now, XIRR looks at:

• Every SIP instalment and its exact investment date

and

• The final redemption amount and redemption date
  

Lastly, it calculates your annual return. So, if your XIRR is 12%, it means your SIP investment actually earned 12% per year, after considering every date and every instalment separately.

 

To Conclude, IRR is the Rate at Which NPV = 0

So now you know that IRR is the rate at which the “present value of all cash inflows” becomes equal to the “present value of all cash outflows”. And when you subtract the two, the Net Present Value (NPV) is always zero. 

IRR is widely used when an investment involves multiple cash flows over time (at equal time gaps). This metric also has a modified version called “XIRR”, which allows you to enter the exact dates of each cash flow. This makes it more accurate for SIPs, staggered investments, redemptions, or any situation where money is invested or withdrawn irregularly.

If you are looking for fixed-income investment options, you may visit the GoldenPi platform. Here you can explore AAA- or AA-rated bonds, corporate FDs from leading small finance banks and NBFCs, and even apply to the latest NCD IPOs.

 

Internal Rate of Return FAQs

Can I use CAGR for computing my mutual fund SIP returns?

No. CAGR assumes a single investment made on one date and redeemed on one date. Since SIPs involve multiple investments on different dates, each instalment has a different holding period. In such cases, XIRR is the correct method to measure SIP returns.

How to calculate IRR?

To calculate IRR, list all cash inflows and outflows with their timing. Next, set NPV to zero, and find the return rate that balances them. Usually, the calculation of IRR is performed using tools like Excel’s IRR/XIRR function or a financial calculator. 

What do you mean by NPV = 0?

NPV = 0 represents the present value of all future cash inflows exactly equals the initial investment. At this point, the investment neither creates nor loses value. The discount rate that produces this zero balance is the Internal Rate of Return (IRR).

 

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