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What is IRR?
IRR stands for the internal rate of return. The IRR is an interest rate which represents how much money you stand to make from an investment, helping you estimate its future growth potential. In technical terms, IRR can be defined as the interest rate that makes the Net Present Value (NPV) of all cash flows from the investment equal to zero.
Say you own a restaurant, and you consider getting a bank loan to develop a larger dining area; you need to know whether this investment is worthwhile or if it will cost more than it gains. If the loan costs 10% and the IRR is 20%, it is a worthwhile investment. If the loan costs 10% and the IRR is 9%, it’s an unwise investment.
IRR differentiates between money at different points in time, on the basis that receiving money now is more useful than receiving it in the future. So if all factors are equal when calculating the restaurant development’s potential, the IRR would be higher for a model where it’s ready in peak season (more money in now), than in quiet season (more money later).
And in short, a larger IRR is a good thing for business.
How is IRR calculated?
Unlike most math problems, where a fixed formula would usually lead us neatly to the result, finding the IRR is not so simple. It’s like shopping for a suit without measurements. We have to use trial and error to experiment with different figures, testing out different percentages in the IRR’s place to see how they fit. Given this slightly cumbersome process, it makes life much easier to use our online calculator. We know when we’ve landed on the correct IRR, as it’s the one which sets the the net present value to zero.
Oh… But what’s a net present value?
What is the net present value?
- Net = after deductions
- Present = current, right this moment
- Value = the worth of something
So if a net present value is a minus number, you’re losing money on that project. If it’s a positive number, you’re making money on the project.
To work out the net present value, add together the present values of all money coming in, and subtract all present values of money going out. So basically, deduct expenses from income. (Present values just means the worth of the money today, not when it’s potentially gained interest a year from now.)
IRR calculation example
Lily bought a jug ($10), some lemons ($10), some sugar ($1), and rented a kiosk for the day ($4). The present values of all her outgoings came to $25.
She then sold 40 cups of lemonade for a dollar each, so the present value of the money in came to $40.
The net present value of her business venture can be calculated by deducting her expenses from her income.
Net present value = 40 - 25 = 15
So Lily’s lemonade stand has a net present value of $15.
Now we need to experiment with interest rates until the net present value becomes 0.
If we were calculating this manually, we could try entering a 50% rate in our spreadsheet, but that would give us a positive number. So we would jump higher, and see that a 70% rate gives us a negative number. So we would try something in the middle, until the NPV comes out at 0, neither positive nor negative. We would then find that Lily’s lemonade stand has a 60% IRR (or 60.01% to be extra precise).
Lily can now go on to work out her profit margin, as another important metric for her burgeoning lemonade business.
What’s the difference between IRR and ROI?
Businesses often talk about their ‘return on investment’ (ROI), which is a useful figure to see how successfully profits outweigh expenses. However, the ROI uses fixed values and doesn’t consider how money changes over time. A investment of $100 in 1976 which returns $200 in 2020 is obviously not such a successful investment as an investment of $100 in 1976 which returns $200 in 1977. So ROI is more meaningful for short-term projects than long-term investments. IRR is more useful for long-term investments, but is best when triangulated with other measurements.