What is the Internal Rate of Return (IRR)? Assessing the Profitability of an Investment
Key Questions Answered
- The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of a potential investment or project.
- In general, the higher an IRR, the more desirable the return of an investment.
- The cost of capital and the opportunity cost of the investor are the determinants of a good IRR.
What is the Internal Rate of Return (IRR)?
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of a potential investment or project. In a discounted cash flow analysis, IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero. Discount rate, in this context, refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
IRR uses the same formula as NPV does. However, it should be noted that IRR is not the actual dollar value of the project but the annual return that equates the NPV to zero. In general, the higher an IRR, the more desirable the return of an investment.
IRR is applicable for investments of varying categories; hence, it can be used to rank multiple prospective investments or projects relatively consistently. Normally, when comparing investment options with similar features, the investment with the highest IRR would probably be considered the best.
In short, IRR can be understood as the rate of growth that an investment is expected to generate in a year. So, it can be most similar to a compound annual growth rate (CAGR). However, in reality, it is hard for an investment to have the same rate of return each year. The fact is that the actual rate of return that a given investment ends up generating usually varies from its estimated IRR.
How to Calculate IRR
The formula used to calculate IRR is as follows:
Ct = Net cash inflow during the period t
C0 = Total initial investment costs
IRR = The internal rate of return
t = The number of time periods
- Using the formula, one would set NPV equal to zero and solve for the discount rate, namely the IRR.
- The initial investment is always negative because it is an outflow.
- Each subsequent cash flow could either be positive or negative, depending on the estimates of what the project delivers or requires as a capital injection in the future.
- Yet, due to the nature of the formula, IRR cannot be calculated easily manually. Instead, it should be calculated iteratively through trial and error or using software programmed to calculate IRR (such as Excel).
The Use of IRR
IRR is used in deciding whether to proceed with a project or investment. If the IRR on a project or investment is higher than the minimum Required Rate of Return (usually the cost of capital), then the project or investment can be undertaken. For crypto investors, it can be used to evaluate the profitability of different crypto projects; when you compare crypto projects with the same advantages and benefits, the one with a higher IRR will be a much more desirable option.
However, IRR is ultimately used to identify the discount rate, which equates the present value of the sum of annual nominal cash inflows to the initial net cash outlay for the investment. It is often perceived as an ideal metric for analyzing the potential return of a new project a company is considering, and not used extensively in crypto trading.
What Is a Good Internal Rate of Return (IRR)?
Keep in mind that the cost of capital and the opportunity cost of the investor are the determinants of a good IRR. For example, an investor might invest in a project with a 20% IRR if his other options offer a 15% or lower return. However, this comparison presumes that the riskiness and effort in making these investments are about the same.
There are cases where the investor obtains a lower-IRR project because he considers the project to be less risky or time-consuming. Generally speaking, when conditions are the same, a higher IRR is better than a lower one.
IRR vs. ROI (Return on Investment)
Traders and analysts also look at the return on investment (ROI) when making investment decisions. ROI indicates the total growth from start to finish of the investment. It is not an annual rate of return.
In contrast, IRR illustrates the annual growth rate, meaning that it is annualized. These two figures would usually be the same over the course of one year but will not be the same for more extended periods of time.
In addition, ROI is the percentage increase or decrease of investment from beginning to end. And it is calculated by taking the difference between the current or expected future value and the original beginning value, dividing by the original value, and multiplying by 100.
ROI numbers can be calculated for nearly any activity into which an investment has been made, and an outcome can be measured. However, ROI is not the most helpful metric for investments that undergo lengthy time frames.
IRR vs. NPV (Net Present Value)
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV uses the same formula as IRR does. The only difference is that the formula is not equal to zero. If a project’s NPV is above zero, it is considered financially worthwhile. If a project’s NPV is below zero, it is not worth undertaking because it will be worth less in the future than it is today.
Plus, when you compare NPV with IRR, it is clear that IRR is usually more useful when comparing across multiple projects or investments or in situations where it is difficult to define the appropriate discount rate. NPV tends to be a better metric when cash flows may flip from positive to negative (or back again) over time or when there are numerous discount rates.
Limitations of IRR
IRR is generally ideal for use in analyzing capital budgeting projects. However, it can be misinterpreted or misconstrued when used in inappropriate scenarios. In the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values. Also, if all cash flows have the same sign (such as when the project never turns a profit), no discount rate will produce a zero NPV.
Within its realm of uses, IRR is widely known for estimating a project’s annual return. Yet, it is not intended to be used alone. IRR is typically a relatively high value, which enables it to arrive at an NPV of zero. In fact, the IRR is only a single estimated figure that provides an annual return value based on estimates. And since estimates in IRR and NPV can stray considerably from actual results, most analysts will combine IRR with scenario analysis, given that scenarios can reflect different possible NPVs based on varying assumptions.
For individuals, IRR is an important metric that can be used when making financial decisions, such as evaluating the profitability of different crypto projects. Also, it can be used to analyze investment returns. In general, the higher an IRR, the more desirable the return of an investment. However, it should be noted that what determines a good IRR is the cost of capital and the opportunity cost of the investor. Lastly, IRR is not without its limitations; for example, it is not intended to be used in isolation.