Internal Rate of Return (IRR) — An Overview
What does IRR mean? - The definition
The term IRR (Internal Rate of Return), in German also internal rate of return , describes a key figure in dynamic investment appraisal. It indicates the interest rate at which the net present value (NPV) of an investment is zero. In plain language, this means that the IRR is the average annual return that an investment generates, taking into account the expected cash flows. If the IRR is higher than the financing costs, the investment is considered profitable.
How is IRR calculated?
Calculating the IRR requires that all deposits and withdrawals of the investment are known. To calculate the IRR, the net present value is adjusted until it reaches zero. The initial investment is regarded as a negative value, while the following payments are rated as positive.
Die IRR calculation can be carried out using specialized functions in spreadsheet programs such as Excel, which offer three IRR functions specifically for this purpose:
- IRR for regular cash flows
- XIRR for irregular cash flows
- MIRR for the modified IRR, which also takes credit costs and compound interest into account.
High vs. low IRR — What does the value say?
A high IRR usually means a good average return and is seen as an advantage, particularly when it exceeds the return on alternative investment options. However, it should be noted that projects of different sizes and durations are difficult to compare with the IRR alone. Depending on the support costs, a smaller project with a high IRR may be less profitable than a large project with a lower interest rate.
It is also crucial that the IRR is above the weighted average cost of capital (WACC). Only this difference remains with the investor at the end.
IRR vs. ROI — differences and areas of application
In addition to the IRR, the Return on Investment (ROI) on the important investment figures. While the IRR shows the internal rate of return on the investment as the average return per year, the ROI shows the overall development of the investment over the entire investment period. However, ROI is less suitable for long periods of time and irregular cash flows. Here, the IRR provides a more relevant result.
Limitations of the IRR method
The IRR provides an estimated return, but under assumptions that are not always true in reality. Some of the IRR's limitations and solutions are:
- Ambiguous interest rates: Projects with varying cash flows can deliver multiple interest rates. The MIRR Excel function helps to achieve more realistic results.
- Reinvestment at internal rate of return: The method assumes that all cash flows can be reinvested at the same interest rate, which is often unrealistic.
- Additional key figures: For projects of different durations, the IRR should be combined with other indicators such as the WACC (weighted cost of capital) to enable a more accurate assessment.
A high level of accuracy in investment valuation can be achieved by combining the IRR with other key figures such as Net present value or WACC (Weighted Average Cost of Capital).
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