IRR makes the Net Present Value (or NPV) for a specific investment equal to zero and is widely used to evaluate investments or projects. By looking at the IRR, a company or business can decide whether or not to accept the investment opportunity based on the desired rate of return.
If the calculated IRR falls above a business’s required rate of return or is comparably larger, they will likely choose to accept the project. On the other hand, if it falls short or another project provides higher yields, the investment may be rejected.
IRR tells you how profitable an investment is; a higher IRR means a higher return on investment. In the world of commercial real estate, for example, an IRR of 20% would be considered good, but it’s important to remember that it’s always related to the cost of capital. A “good” IRR would be one that is higher than the initial amount that a company has invested in a project. Likewise, a negative IRR would be considered bad, as it would mean that the cash flow received from the project was less than the amount that was initially invested.
In order to fully understand the mathematics behind IRR, it’s also important to know about NPV since the two are closely tied together. NPV (or Net Present Value) is the difference between the market value and the total cost of an investment. Investments with a positive NPV will earn you money, while those with a negative NPV will lose money. So, for example, to calculate the NPV of a property, you would first need to determine what other comparable properties are selling for to find its market value. Then, you would need to calculate the costs of purchase, renovation, and running the property (this is the total cost). If the total cost is less than the market value, you would have a positive NPV.
So, how does this relate to IRR?
Well, once you know the NPV, the IRR is the interest rate that would make the market value and total cost equal to zero.
You can calculate IRR in Excel, or you can do so manually by setting the NPV equal to zero and solving for r using the following formula:
To calculate the IRR using the above formula, you would begin by setting the NPV equal to 0, as in the equation above. You would then solve for IRR (sometimes written as just r). However, because of the nature of the equation, IRR cannot actually be calculated analytically. Instead, you must test several scenarios or using computer software such as Excel or an online application.
Put simply, a “good” IRR is one that you feel gives a sufficient return on your investment, which means there isn’t necessarily a numerical value that can be considered good as a rule of thumb. Since it depends on the initial investment amount and personal preferences, it is subjective. IRR is measured using percentages, so generally speaking, if the IRR is higher than the discount rate, it means the project shouldn’t be losing money.
Many people find IRR more confusing to calculate than ROI, which is why ROI is often more popular. ROI stands for Return On Investment and is the percentage increase or decrease in an investment over a set period and indicates total growth from start to finish where IRR is used to determine annual growth rate.
As with most things, there are pros and cons to using IRR. On the plus side, IRR allows you to estimate the time value of money as it considers the timing of cash flow in future years. It also enables businesses and companies to see a snapshot of what potential investment projects are most likely to be valuable. Once a company knows the IRR of an investment, it easily allows them to determine which projects are going to exceed the estimated cost of capital.
However, there are some downsides to IRR. Firstly, IRR doesn’t consider future costs; it projects cash flow generated based on the initial capital costs but doesn’t take into account any future unpredicted spending that may affect profit. Additionally, it doesn’t take the size of the projects into consideration, which can become a problem if two different projects are being compared that require different capital investments. For example, a project that costs more money to invest in may have a smaller IRR (by percentage) when compared to a project that requires a lower capital investment. But that same large project could still yield a higher overall cash flow.
All in all, IRR is an essential and important way for businesses to determine which projects are worth investing money into. In real estate, this can involve development projects, investment into rental properties, or the costs of buying or building a new home. It is particularly useful for companies that might have multiple attractive investment options and want to know where to best invest their capital.