The internal rate of return, or IRR for short, is a crucial calculation that can reduce complicated investment decisions down to a single number. A quick way to check up on this figure is to use an IRR Calculator.
In this article, you'll find everything you need to know about the internal rate of return: what it is, how to calculate it, and how to use it. Most importantly, we'll show you the benefits of using an internal rate of return calculator for business owners and investors alike.
IRR is a measure of the profitability of an investment. And it's one of the first things you should look at when making a decision about where to put your money.
It's a concept that applies to a wide range of situations. Large corporations use IRR to determine which investment opportunities to pursue. And families use IRR to determine which real estate to invest in.
The IRR is a percentage that represents the rate of return on an investment, business expansion, or project that involves cash inflows.
IRR is a simplified model. Being an "internal" rate, it only considers internal factors (that means it ignores things like inflation). But nonetheless, it's a powerful tool and a good first measure to take when considering a new investment.
Let's assume you have the opportunity to make a $100,000 real-estate investment. That investment could require additional capital, say, towards mortgage payments or maintaince, while the property appreciates in value.
IRR would balance these factors to down tp a single annual rate of return.
Our IRR calculator is very easy to use. Begin by entering a start date. This is the date on which you'll make your initial investment.
Then, go down to the transactions pages and list out all your future payments. If you'll be receiving regular payments of equal value, you can set up a regular payment schedule. Otherwise, you can enter individual transactions.
Finally, enter the end date that corresponds to the end of the investment period. And enter the amount you expect to receive on that date (or the value of the investment on that date) as the final value.
And just like that, you have your internal rate of return.
It all starts with the net present value formula:
Where C0 is the initial investment.
The t terms represent the various time periods (usually considered in years: year 1, year 2, etc).
The Ct is the amount of revenue you expect to earn during time-period t.
And the r term is the rate of return.
NPV gives you the current value of a potential investment. It condenses all future cash flow into one number so you can compare the value of the investment to the value of other assets.
When calculating NPV, you choose the r value (rate of return) based on a number of factors including interest rates and the risk of the project.
IRR is related to NPV. To find the investment's IRR, leave r as a variable and set NPV to zero. Then, solve for r.
Another way to think of it is that you're setting your initial investment equal to all future earnings.
But don't worry, you won't have to actually solve for r. In fact, solving for r analytically is complicated and requires a certain apptitude for mathematics. Instead, we recommend using an IRR calculator.
To better understand the internal rate of return, let's take a closer look at the equation.
The most confusing part of the equation is the sum. So let's simplify it by imagining an investment that only makes one payment.
Imagine you invest $1000 in a project. And you know that the project will yield $1100 in 5 years. Let's assume it doesn't make any payments between now and then.
In this case, the IRR equation is simple. It's C0=C5/(1+r)5 or $1000 = $1100/(1+r)5.
Now, let's rearrange the equation so that it's $1000(1+r)5=$1100. In English, this says, "what annual rate of return, r, do I need if I want $1000 to grow to $1100 over five years." If we solve for r, we find r = .01193 = 1.193%.
In other words, making this investment is equivalent to putting your money in a bank account at 1.193% annual interest and taking it out after five years.
Now, imagine you take out some money every year. We'll need to add in the intermediate terms.
You can think of all those intermediate terms in the same way. It's as if you put $1000 in a bank account at an annual interest rate of r, and then took out a certain quantity of money after t years. But of course, r will change if you take money out earlier.
By dividing every term by (1+r)t, the equation is telling us that it's better to receive money sooner than later (this is the time value of money). If you receive a payment far into the future, t will be large, the denominator (1+r)t will be large, and thus, the effective payment will be small.
You should use IRR to compare two potential investment projects. Or you can use it to decide between expanding a current project and investing in a new one.
As we explained above, making an investment is sometimes equivalent to putting the money into a bank account at interest rate r. So, if you can make a greater yield by investing in the financial market, don't opt for the bank account. Invest in the financial market instead.
This is why the Federal Reservelowers interest rates when they want to encourage investment in new projects. If the interest rate in the financial market is low, then your project's IRR is more likely to beat the interest rate. And thus, you're more likely to make the investment.
And you don't have to be a big corporation to take advantage of IRR. It's also a valuable tool for evaluating smaller investment decisions such as real estate purchases.
Now that you understand the internal rate of return and you know how to calculate it, it's time to take advantage of your new tool.
Next time you need to make an investment decision, start with IRR. If the IRR is higher than the IRR of your next best option, make the investment.
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