What is Internal Rate of Return and How to Calculate it?

The Internal Rate of Return, or IRR, is one of the most popular financial tools used to decide the profitability of an investment. It helps to determine the annual growth rate of an investment needed. When confused between two or more investment opportunities, that’s where the IRR comes into play. However, for new investors, understanding the concept of the IRR can be a bit of a challenge. So, let’s sort out this confusion and break down what the Internal Rate of Return is and how it works.

What is IRR in Finance?

The meaning of IRR is the specific discount rate at which the Net Present value (NPV) becomes 0. Simply put, the Internal Rate of Return is the rate at which the initial cash investment is equal to the present value of your future returns or cash flows.

These financial terms may be confusing for novice investors. So, before we explain what IRR is, you need to know some investment jargon and its concept. Let’s also delve into the importance of each in calculating the Internal Rate of Return.

We will consider an example, suppose you invest ₹1,000 for 3 years, and you expect a return of ₹1,500. Taking this example, let’s dive into the details of calculating the IRR and other metrics.

1. Investments, Returns, and Cash Flows

The IRR is not the first thing that investors, especially beginners, think of. What you usually check is its Return on Investment or ROI.

Investment = ₹1,000
Return = ₹1,500
ROI or profits = ₹500
ROI percentage = 50%

The money that goes in and out, that is, what you invest and what you earn as a return, is called cash flow.

Money spent or invested = Cash Outflow
Returns including profits = Cash Inflow

Although the Return on Investment or ROI tells whether you earn profits or not, it neither counts the duration in which you earn that profit (3 years in this case) nor the time value of money, which refers to the difference in value of the same amount of money today and in the future. However, it will be factored into the Internal Rate of Return calculation.

2. What is the Time Value of Money?

Save money in a home locker rather than investing it?

You lose: Additional earnings through compounding interest + your money’s value and purchasing power.

With inflation, your buying potential decreases. What you can purchase with ₹1,000 today, you will probably buy less in the future at inflated prices. This principle is called the time value of money, where the same amount will hold less value in the next 3 to 5 years than it does today.

Assume that you make a profit of ₹500 in 3 years. But the real questions are -

Will it be worth the investment of ₹1,000 today?

Or if the total returns of ₹1,500, including the profit, will hold an equivalent value or even less than today’s ₹1,000?
You need to calculate the time value of returns before you invest.
For TMV calculation, there are a few financial indicators required: the future value of money (expected returns), the discount rate, and the number of years you want to invest. You can then calculate the present value — how much you need to invest.

3. Discount Rate

Imagine you invest in a compounding interest investment option, such as a bank fixed deposit. You calculate the future value (FV) of your invested money at its present value (PV), factoring in the rate of interest or CAGR (compounding annual growth rate) and the time period for which you stay invested.

Likewise, you can calculate the present value of your future returns at a benchmark rate, which is the discount rate. It is also known as the hurdle rate or minimum acceptable return. By benchmark rate, we mean rates offered by safer or guaranteed investment options like bank FD or government bonds. So, take that as the discount rate because you should take an investment project if it beats those returns and meets your opportunity cost of capital.

When you calculate backwards, that is, the present value back from the future value of your cash inflows, it is called the Discount Rate.

Also Read: 5 Investment Plans for Beginners in 2025

4. Net Present Value or NPV

For calculating an investment’s profitability considering the time value of money, we use the metric of Net Present Value or NPV. Here’s how you do it -

Convert your expected future returns or cash inflows into their present value using the discount rate. Now, they can be compared with the invested money or cash outflows of today, so you subtract today’s cash outflow from the present value of your returns to get the Net Present Value.

For example that we have taken to calculate the NPV,  convert your future return/cash inflow of ₹1,500 in today’s value, and minus the investment/cash outflow of ₹1,000.

1. If the NPV is positive (more than zero), it means the investment is profitable, considering the time value of money.
2. If the result is negative, then it is not worth investing, because even if you get profits, the time value of money makes their worth less than your invested money.
3. If it’s neither positive nor negative but zero (0), it means your profitable returns from the future will hold the same value as today’s invested amount. Also, the discount rate IRR Calculation

5. IRR Calculation

The discount rate or rate of return at which the NPV of all your cash flows becomes zero is the Internal Rate of Return. The IRR is often called the break-even return rate. You will have to keep adjusting the discount rate till NPV is 0.

Once you determine the IRR, you compare it with the minimum required return rate at which your investments are expected to grow to give you the desired results. If the IRR is higher, then the investment project will give you profits.

How does IRR Work? How to Calculate IRR?

The IRR, or the Internal Rate of Return, is the average yearly growth rate your investment must give you. An investment is profitable when the IRR meets or is less than the return rate. When you have multiple investment options against you, you can compare their IRR and decide which investment avenue you should pick.

The Internal Rate of Return Formula is :

0=NPV=t=0∑n​(1+IRR)tCt​​
Where the IRR is the discount rate for NPV = 0. Here,
C0 = Cash Outflow/ Investment at the time ‘zero’ (present time).
Ct = Cash Inflow/Returns at time ‘t’ 
‘t’ = time period of the cash flow (such as cash inflow after year 1, year 2, and so on)
‘n’ = Number of years of the total investment period.

Once the Internal Rate of Return calculation is done, compare it with the given rate of interest that your investment project promises. If the Return Rate > IRR or Return Rate = IRR, then it's profitable. If Return Rate < IRR, you must think before investing.

Also Read: How to start a business with zero investment in 2025?

IRR vs Other Metrics

Beginners or novice investors often confuse IRR with NPV, ROI, or Discount Rate. But, before investing, you should understand the difference among them all.

IRR Vs ROI (Internal Rate of Return Vs Rate of Interest)

ROI is simple to calculate. The IRR calculation is more complex. ROI does not factor in the time value of money.

IRR Vs NPV

(Internal Rate of Return Vs Net Present Value)

NPV shows the total growth after all cash flows in an investment, whereas IRR shows the yearly growth in percentage, considering NPV to be 0.

IRR Vs DR (Internal Rate of Return Vs Discount Rate)

The Discount Rate is used to calculate the PV (present value) of your returns and helps in NPV calculation. IRR is calculated when NPV = 0.

IRR vs Payback Time

The Payback Time or Payback Period is the expected time by which you can get your invested money back. IRR indicates the annual growth rate and predicts the payback time.

Summing Up

The Internal Rate of Return is an essential tool popular among investors to check how profitable an investment plan is. However, the IRR, along with its benefits, also has some limitations. While it helps in understanding the investment value and comparing projects and factors in the time value of money, it is also very sensitive to cash flow estimates. If forecasts are uncertain, it can be misleading. Hence, it cannot be the sole decision-making factor.

FAQs on Internal Rate of Return