Understanding Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. Unlike ROI, which just looks at start and end points, IRR accounts for the timing of cash flows. It is the discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero.
When to Use IRR?
Use IRR whenever money is moving in and out at different times. Examples:
- SIP Investments: You invest monthly (multiple outflows) and withdraw once (one inflow). Simple CAGR cannot calculate this accurately; you need XIRR (Extended IRR).
- Business Projects: You buy a machine today (Outflow), and it generates revenue for 5 years (Inflows).
- Insurance Policies: Money back policies where you pay premiums for 10 years and get money back in intervals.
Interpreting the Result
If the IRR is higher than your "Cost of Capital" (or the interest rate you could earn in a bank FD), the investment is good.
- IRR > 10%: Generally good for conservative equity or balanced funds.
- IRR < 6%: Poor. You are better off putting money in a Fixed Deposit.
- Negative IRR: You are losing money on the project.
IRR vs. CAGR
CAGR (Compound Annual Growth Rate) assumes a single lumpsum investment at the start and a single withdrawal at the end. IRR handles multiple deposits and multiple withdrawals. For SIPs, IRR (specifically XIRR) is the only correct metric.
Limitations of IRR
IRR assumes that all future cash flows are reinvested at the same rate as the IRR itself, which can be unrealistic for very high IRRs. It also struggles with alternating positive and negative cash flows (multiple solutions).
Modified IRR (MIRR)
Standard IRR assumes you reinvest cash flows at the same high IRR rate. This is often dangerous. For example, if a project has an IRR of 50%, it assumes you can find *other* projects that also give 50% to reinvest your profits.
MIRR (Modified Internal Rate of Return) solves this by allowing you to set a separate "Reinvestment Rate" (usually a safe rate like 7% FD). MIRR is always lower than IRR for positive projects but is more realistic.
IRR for Startups vs Real Estate
- Startups: VCs target an IRR of 30% because the risk of failure is high.
- Real Estate: An IRR of 12-15% is considered excellent for development projects.
FAQs
- Why is the initial investment negative?
- In cash flow analysis, money leaving your pocket (Investment) is negative (-), and money entering your pocket (Returns) is positive (+). The math requires this distinction to solve for zero NPV.
- Is XIRR different?
- Yes. IRR assumes time intervals are equal (Years). XIRR allows specific dates for each transaction. For monthly SIPs, they are practically similar.
- Can IRR be zero?
- Yes, if the sum of your cash inflows exactly equals your initial investment (0% profit), the IRR is 0%. If inflows are less, IRR is negative.