What is IRR and How to Calculate the Internal Rate Of Return
There is a difference between the Internal Rate of Return (IRR) and the Rate of Return.
To help you understand how they differ, let’s imagine two situations: one defines the Rate of Return, and the other explains the Internal Rate of Return.
In my real estate investing, I always look to the IRR as a way to make sure I am spending as little money as possible, while making the most money in return.
So, what is IRR? The best way to explain is to give you an example.
Imagine giving your friend $100, and every year, your friend gives you $5 back and will give you $5 during your whole lifetime. The $5 you receive is equivalent to 5% because $5 of $100 = 5% out of 100%.
IRR Is the Percentage of Money Returned to You From Your Investment
The Internal Rate of Return is when you give your friend $100, and every year, he gives you a return. However, the rate is indefinite.
For example, this year, he gives back $3, but next year, he gives back $50. He will not continue to give you money for a lifetime but only for eight years. This is the Internal Rate of Return.
To define the Internal Rate of Return, it is the rate or percentage of interest in which the net present value of the total cash flows, regardless if it is positive or negative, from an investment or a project that is equal to zero.
How IRR is Used for Investing
The IRR is used to measure if a project or investment is appealing. If the Internal Rate of Return is over the organization’s Rate of Return, then that investment or project is good.
However, if it falls under the required Rate of Return, then the investment or project should not be pushed through.
Calculating the IRR is helpful for organizations and businesses since they can get an overview of the returns of their investment.
Aside from entrepreneurs, marketing teams can also use this to have a goal or strategy on how they should execute a promotional or marketing plan.
The IRR is also a useful process when it comes to real estate because there are properties and returns involved, so you can measure if the property you are planning to purchase is worth buying.
In summary, the Internal Rate of Return (IRR) is the best way of checking if an investment is good or bad. The higher it is, the better it is.
What is the formula for IRR?
How to calculate IRR can be a trial and error process since you are trying to get the present value of the investment or project’s cash flow to be equal to zero.
When you are calculating the Internal Rate of Return (IRR), the expected cash flow of the investment or project is to be given, and the Net Present Value (NPV) is equivalent to zero.
The investments or projects’ present value of future cash flows should be equivalent to the initial cash investment for the beginning period.
Therefore, the cost paid is equal to the present value of future cash flows. Thus, the NPV is equal to zero.
There are several factors that you should keep in mind in deriving the formula in how to calculate IRR:
There are two main formulas that can be applied to calculate IRR:
However, there are other ways of computing it. One is through inputting data with the help of Microsoft Excel, and the other is having the data computed using a quick formula.
That does give accurate data since there is some data you don’t have to use to apply the formula.
How to use IRR for investing in real estate
Calculating the Internal Rate of Return (IRR) in real estate is a great tool in knowing and estimating the investment or project’s profitability.
IRR is helpful when it comes to long-term investments in real estate because you can get an overview of the Rate of Return you will be generating from the start of the investment to the end.
However, as mentioned previously, calculating the IRR can involve some trial and error, but it will be a result that’s worth it when completed successfully because you can see the future movement of the investments and can create a plan from there.
As good as it sounds, there are also some factors that can put your calculations to waste, and these are things you should keep in mind.
When there are sudden expenses that appear in the next year or other factors that affect the price, you’ll need to calculate the IRR again because the first one you did will now be invalid.
Be vigilant and remember this because you might not have considered the sudden costs that appeared, and you might still be following the same data you initially had.
A little advice to make it easier is to stick to the same industry or to categorize similar properties that amount to almost the same risks and holding period.
You will have fewer possible errors in choosing the right project or investment.
How to use IRR in Microsoft Excel
In using the IRR in Microsoft Excel, things are easier since the application does the calculating for you. It is a financial function that gives the IRR for a series of cash flows that happen at constant, regular intervals.
Let’s imagine AJP Industries is investing $500 and wants to know if it’s a good investment. Project the increase in your profits by $100 every year, starting with $100 in the first year.
In encoding the data, start with the first column with row 1 as Period 0 and row 2 with the $500 investment.
Remember, this is a negative number because you paid $500, so this should be a minus to the data you have.
Column 2, Row 1 starts with Period 1, which should have $100. Period 2 should have the year 2 return of $200, and lastly, Period 3 is $300. On the rows below these periods, input the amount of investment.
This will be what your Microsoft Table will look like:
Choose an empty cell and input this formula: =IRR (B1:E1)
Remember, the B1 and E1 depend on where the cell is on your Excel sheet. B is for the column and 1 is for the row number. Change the formula depending on where your data is located.
When the formula of how to calculate IRR is used, the result is 8.2%. The result will automatically show when you enter the formula in any other cell that is not part of the table with the period and the return amount inputted.
It will also automatically change and update once you change the data in the existing table.
It does not mean that you have to encode the data in those cells. You can input anywhere in Microsoft Excel’s sheet, but be sure that you move the formula to their accurate locations.
This is how easy Microsoft Excel calculates IRR. It is nice to save some time and use this process rather than computing and undergoing the whole trial and error process because data might be invalid.
Another benefit of using Microsoft Excel is that you can store your data, and you also have the convenience of changing the cash inflow if there are sudden costs that are occurring during the investment periods.
How do you calculate IRR manually?
In calculating the Internal Rate of Return, you would need to expect more guessing because it will be a trial and error computation.
Let us try using an interest rate of 10% for this example:
A businessman asked you to invest $2,000 for the three-year project he is working on. Each year, a payment of $100 is made, and in the last year, a payment of $2,500 is made.
Currently, the Present Value is negative $2,000.
- For the 1st year: Present Value = $100 divide by 1.10 = $90.91
- For the 2nd year: Present Value = $100² divide by = $82.64
- For the 3rd year: Present Value = $100³ divide by = $75.13
- And for the final payment of the 3rd year: Present Value = $2,500 divide by 1.10³ = $1,878.29
So, when these are all added together, this is the NPV:
- Net Present Value = -2,000 + 90.91 + 82.64 +75.13 + 1878.29 = $126.97
What is a quick IRR calculation?
Having a fast IRR calculation is possible, and you don’t have to compute everything entirely. However, this can only be possible when you have the right conditions.
Keep in mind, when calculating the IRR quickly, these will be an overview and an estimated result since there are dividend recaps, asset sales, and other expenses and sales that will vary the result.
First is to have the discount rate equal to the Net Present Value of cash flows from an investment equaling 0:
Like the long method, you also have to do a trial and error in calculations. In using quick IRR calculations, you can only achieve this when there is data that you will not carry out or use.
This is not an advisable way when you’re doing it for the purpose of investing because this does not give you accurate data to risk a big amount of money for investments.
It would be best to use Microsoft Excel for more accurate data.
To summarize everything, IRR is a good way to judge if the investment or project is good. It would be nice to have this as a basis in deciding to push through a project you are planning to invest in.
Internal Rate of Returns are advisable for long-term negotiations and transactions because it is more accurate.
However, we have to keep in mind that if there are sudden costs in the periods, the IRR you initially computed will become invalid.
So, it is recommended to use Microsoft Excel to easily store the data. If the need to update the data arises, the IRR also automatically updates itself without you having to undergo the whole trial and error process.
Not every individual is good at computing, and since this is a matter of investment and money, this is not something we can just play with or practice our math with.
If the computation is confusing and hard for you, it would be better to have a financial advisor help you understand the data so that you can apply your understanding of the IRR and its data to your business, project, or investment.
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