Calculate the internal rate of return for a series of regular cashflows

What is the internal rate of return (IRR)?

The internal rate of return (IRR) is the discount rate of a given series of cashflows that take place in regular intervals of time such that their net present value is equal to 0. When evaluating potential investments or projects, IRR tells us what the minimum threshold of an investment should be in order for it to be considered, e.g. if the IRR defined by a person is 10%, then only investments which have an IRR larger than 10% would be considered.

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The IRR can be used to compute the returns on SIPs and other investments but it neglects "when" these cashflows take place. If its a yearly SIP, IRR can be used accurately but it's a simplification, i.e. if the periods are irregular, then IRR is not suitable as it conceals the real picture. For irregular periods and more accuracy, XIRR should be used. Currently XIRR is in development and not yet offered on this website.

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When should I use IRR?

In the financial sense, IRR is useful to determine how profitable an investment (or a series of cashflows) is. IRR is used when the cashflows are evenly spaced, usually in years. The IRR can only be calculated if at least one cashflow is negative. IRR can also be used to assess lumpsum investments that pay out dividends annually.

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When comparing investments, suppose an equally risky investment had a higher IRR, then the investment with the higher IRR would be a better choice. Similarly, if there were multiple investment options, and the investor decides to only consider those options which return at least 10%, then the IRR of each investment option would be evaluated and all those with an IRR lower than 10% would be eliminated. 

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How is IRR estimated?

The formula that can be used to estimate the IRR along with an explanation of the  terms is provided above. This formula assumes at least one negative cashflow and equally spaced cashflows (e.g. yearly cashflows)

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What is an example of IRR?

Assume an investment of ₹100,000 invested initially that pays out  ₹5,000 to the investor for 5 years and is then sold in the 6th year for a price of ₹1,20,000. In such a case, the series of cashflows in would be -100,000 | 5,000 | 5,000 | 5,000 | 5,000 | 5,000 | 1,20,000. The IRR for such an investment would be 7.09% assuming that the annual payouts of ₹5,000 are not reinvested in some way. With an IRR of 7.09%, the net present value would be 0. 

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Suppose the investor decided, that he would only invest if he gets an IRR of at least 10%, then he would reject the investment example described above as it has an IRR of 7.09%. The reason is that an IRR of 7.09% implies a net present value (NPV) of 0 and a discount factor of 7.09%. If the discount factor that the investor works with is 10%, then the IRR of 7.09% would not be used while calculating the NPV. In this case the NPV of the investment would be -13,309.19 and this would, from the view point of the investor, be unacceptable or unprofitable.

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Note:

If an investment fulfills the IRR and/or NPV criteria, it does not automatically mean it is a good investment. If we compare investment option A and B below, we see that the IRR is equal but investment A starts paying back returns sooner. If the risk of both investments is equal, then investors would usually prefer option A, unless there is a strong reason to defer returns, e.g. by going for option A, there may not be any other follow up investments with an IRR of 10% or more. If an investor perceives the risk of A to be significantly larger than that of B, then selecting option B could make sense. Therefore, while comparing investments, it is important to look at other factors such as risk, the nature of the payouts, the breakeven point, liquidity constraints, liquidity requirements, investment objectives etc.

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Investment option A with an IRR of 10%

Investment: 10,000

Cashflow year 1: 5,000

Cashflow year 2: 5,000

Cashflow year 3: 1,762

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Investment option B with an IRR of 10%

Investment: 10,000

Cashflow year 1: 0

Cashflow year 2: 0

Cashflow year 3: 0

Cashflow year 4: 0

Cashflow year 5: 0

Cashflow year 6: 16,109

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Why is this IRR calculator useful?

This IRR calculator is useful as it can help with retirement planning or investment planning. It's also a good way for beginners and professionals alike to estimate the returns from a series of investments and to make better decisions.

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How do I use this IRR calculator?

Instructions to use this IRR calculator are provided above.