Internal rate of return and how to calculate it easily.

IRR is a coefficient reflecting the minimum level of profitability at which an investor can invest without any loss (it will go “to zero”).

Internal rate of return and how to calculate it easily.

Internal rate of return and how to calculate it easily.

IRR is a coefficient reflecting the minimum level of profitability at which an investor can invest without any loss (it will go “to zero”).

 

In fact, this is a rather complicated issue, which is closely interconnected with the concepts of net present value and discount rate. Before delving into the essence of this concept, I propose a little understanding of the principles of “discounting,” that is, assessing the future value of money. I recommend that you initially read the articles at the above links, here we will consider these issues superficially.

In fact, breakeven for an investor means that NPV (Net present value, NPV) should be zero, that is, it turns out that the future value of the investment will be equal to the present value. So you can make a simple conclusion:

The minimum yield to exit to zero (IRR) should be equal to the discount rate. Unclear? Yeah me too!

In general, when investing, you can go from two sides:

  1. Estimate future cash flow based on a discount rate
  2. Estimate the minimum discount rate based on future cash flow.

If we consider NPV, then we follow the first option and bring the future value to current money. If you consider GNI (IRR), then we follow the second option, that is, we consider the minimum rate at which the future value will be equal to the current one.

 

Let's look at an example.

Suppose we have a proposal for an investment in a property worth 100 thousand rubles. At the same time, the investment period is 5 years, and the expected income over the years is as follows:

1 year - 15 thousand;

2 year - 20 thousand;

3 year - 30 thousand;

4 year - 35 thousand;

5 year - 40 thousand.

Total income - 140 thousand.

 

As I said above, we are interested in exactly the discount rate at which NPV will be zero, that is, in this formula we are looking for not the NPV (we put 0 instead), but the discount rate. It is the discount rate that will be variable and it will be equal to IRR, that is, the rate of return at which we will go to zero.

 

Modern technologies allow you to read IRR automatically, for this we need a simple Excel. To calculate the IRR in this program, you must do the following:

1. Enter the data.

2. We find in the financial formulas the function "IRR".

3. Select the fields of interest to us.

4. We look at the resulting IRR value.

In this case, it turned out that the IRR is 9%, that is, this is the rate of return, at which we will get "zero".

 

What does it mean?

Now for the interesting part. Logically, we can assume that if our IRR is equal to the discount rate at which we will go to zero, then if the real return on parallel investment options is higher than our IRR, then we should invest in parallel projects, if the situation is reversed, then into the project in question.

However, in most cases, the IRR indicator is assessed in situations where investments are made by attracting credit funds, that is, a certain rate of return (loan rate) that we must cover in order to make a profit. In this case, the IRR is a kind of indicator of loan profitability, that is, if the IRR results in more than the loan rate, then the project is profitable, if the IRR is less, it is not profitable.




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