When banks consider potential investments, they take into account some of the same factors that companies and individual investors analyze. Although investments are speculative by nature, if a bank or other investor can determine a more reasonable rate of return from a particular investment when compared to other investments, it could tip the balance toward making a certain investing decision. The internal rate of return (IRR) helps investors estimate how profitable a potential investment may be, whether the investor is a bank, another type of business or an individual investor.
What Is IRR?
As a metric that’s used in estimating investment profitability, IRR shows the growth on an investment over a specified time period. It’s a way to analyze the performance of the compounded annual percentage rate (APR) on each investment dollar. And from a mathematical perspective, it represents a discount rate that adjusts the net present value (NPV) of total cash flow to zero.
The reason that NPV represents zero is that the initial cash investment equals the investment's present value of its future cash flows. And since future cash flows haven't happened yet in the beginning of an investment, its net present value is zero.
The "Internal" in IRR
"Economic rate of return" and "discounted cash flow rate of return" are two other designations for IRR. "Internal," as represented by the IRR acronym's first initial, simply means that this metric doesn't consider external factors such as inflation or capital costs.
IRR Vs. ROI
Even though IRR reflects the APR of each investment dollar, it doesn’t represent the actual return on investment (ROI). Although IRR and ROI are similar concepts, one of the primary differences lies in the time frame that each concept represents. While IRR is useful for showing investors what the annual growth rate is, ROI shows investors the big picture – the total growth of an investment from start to finish. With exceptions, these two numbers typically are the same during the span of a year, but they diverge when compared over longer time periods.
For this reason, ROI may not be the best indicator of an investment’s long-term growth potential. The longer an investment period, the more challenging it can be to project ROI. This is why many investors prefer to use IRR as a more predictable metric for short-term investments.
Applications for IRR
Various investing sectors find IRR useful in analyzing investment profitability. When a company or corporation considers a project, which can either increase profits or reduce current costs, it may calculate IRR. When banks or other companies consider investments, which cut into their capital budgets, they want to know the IRR for these investments. Calculating IRR in these two examples can help guide project decisions and investing moves by determining reasonably expected returns.
IRR Formula Example
There are various ways to calculate IRR manually.
One formula is:
IRR = R1 + (NPV1 x [R2 – R1]) / (NPV1 – NPV2)
R1 and R2 = randomly selected discount rates
NPV1 = higher net present value
NPV2 = lower net present value
This formula contains numerous variables such as investment amount, total investment timing and the investment’s cash flow. Other methods for calculating IRR are more complex to account for these and other variables.
Easier Ways to Calculate IRR
If math's not your thing, even the basic formula noted above may make your head hurt. But if you try to use one of the more complex formulas for calculating IRR, you may really strain your brain. A simpler solution? Use an IRR loan calculator, such as an HP 12C financial calculator, or a spreadsheet program, such as Excel’s IRR function, to do this calculation for you.
When Is High IRR Better?
Generally, a higher IRR is preferred over a lower IRR, because this represents a higher overall rate of return for an investment. Investors see a higher rate of return as an indicator of a higher rate of cash inflow. Although an investment’s net present value is an important consideration, many investors look toward the annual rate of return from IRR since daily values can fluctuate.
When Is Low IRR Better?
Sometimes, a lower IRR has greater value than a higher IRR. Even though a high IRR in the short-term looks attractive, it may actually yield little return. One consideration is the size of the investment. It’s possible that a lower IRR has more value on a large project than a higher IRR on a small investment.
For example, at face value, an anticipated 15 percent IRR from a potential investment may look more appealing than receiving a 10 percent IRR from a different investment. But if you earn $1,500 from a $10,000 investment (15 percent IRR), you won’t make nearly as much in the long run than if you earn $10,000 from a $100,000 investment (10 percent IRR). In this example, the lower IRR actually yields a higher ROI.
Positive Vs. Negative IRR
A positive IRR indicates that a potential investment is likely to make a profit or that a proposed project will return value after its costs are paid. Conversely, a negative IRR indicates that an investment may lose money or, in the case of a proposed project, cost more than the value it returns. If you properly calculate IRR, you’d want to steer clear of investments or business projects that yield a negative IRR.
Downsides When Calculating IRR
One downside when calculating IRR is that an investment must have an initial cash outflow, which is the cost of the investment, plus at least one cash inflow for IRR to return a valuable prediction. Otherwise, the results will be skewed.
Another downside is the failure of the IRR calculation to consider an investment’s absolute size or its return. This means that the IRR formula produces a higher IRR for a $1 investment that yields a $3 return than a $1 million investment that yields a $2 million return. The IRR math is correct, but the higher IRR produces only $2 profit while the lower IRR produces $1 million profit. In addition, calculating IRR doesn’t work if an investment has interim cash flows.
Another failure of the IRR formula is that it doesn’t consider the capital cost of a project or investment, and it cannot accurately compare different projects that have different durations.
Modified Internal Rate of Return
Instead of solely looking at IRR to assess a potential investment's profitability, there's another calculation that fine-tunes the IRR metric. Unlike IRR, the modified internal rate of return (MIRR) formula helps compare investments or projects that have dissimilar characteristics or durations, which improves the IRR formula. Another departure from calculating IRR is MIRR's assumption that all positive cash flows are invested back into a company's capital costs and the initial costs are financed through the firm's financing cost.
Instead of manually performing the detailed formula to calculate MIRR, you can use Excel's MIRR function to calculate it for you.
- INTERNAL | meaning in the Cambridge English Dictionary
- Forbes: Tempted by a High IRR? Don't Be, It's a Misleading Statistic
- Internal rate of return - Wikipedia
- Corporate Finance Institute: Internal Rate of Return (IRR)
- Corporate Finance Institute: HP 12C Calculator
- Investing Answers: Internal Rate of Return (IRR)
- Modified internal rate of return - Wikipedia
- Corporate Finance Institute: MIRR Guide
- Compare the results of different investment options against your expected rate of return. If you need 10 percent to make a reasonable profit and keep your job, calculate the IRR multiple times, given all possible loans you are considering. If one result is .24, this is more than twice the 10 percent you expected. If another is .50, this is five times the amount. Go with the latter option.
Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.