What is IRR and Why is it Important?

Calculating investment returns isn’t as straightforward as it sounds. There are multiple ways to calculate the return of an investment, and each has its own benefits and drawbacks.

IRR, which stands for Internal Rate of Return, is one of the more popular methods. IRR is the annualized compounded return rate that can be earned on invested capital, or in simpler terms, the yield of the investment.^[1] The significance of IRR lies in its ability to provide a single rate of return that takes into account the time value of money, making it a powerful tool for comparing the potential returns of different investments.^[2]

What makes IRR so useful is that it allows investors to assess the attractiveness of an investment by calculating its future value, and then determining the investment’s present value in today's dollars, which is crucial for understanding the investment's risk.^[3] This can then help investors compare two complex investment strategies–say investing $10,000 into a private credit deal, vs. investing the same $10,000 into a private equity deal.

In this article, we'll explore what IRR is, how it’s calculated, the benefits and drawbacks of using IRR, and how it compares to other return calculations like ROI.

Key Takeaways:

• IRR is the annual rate of growth that an investment is expected to generate. It is calculated using the same concept as net present value (NPV), except it sets the NPV equal to zero.
• IRR takes into account the time value of money, which is critical when attempting to understand an investment’s value over long durations of time.
• While the formula for calculating IRR is extremely complex, available software can provide IRR calculations easily. This can help investors compare complex investment opportunities like private credit vs. private equity.

Key Terms

Before we explain more about IRR, it's important to run through some definitions of key terms:

Discount Rate: The interest rate central banks charge on loans, which they advance to commercial banks. This is NOT the Fed Funds rate, which is the rate at which banks can lend money to one another (also set by the Federal Reserve). The discount rate is the interest rate banks must pay the Fed when they borrow money directly from the Fed (typically the Fed acts as a lender of last resort). The discount rate is usually–though not always–around 100 basis points above the Fed Funds rate.^[4]

Return on Investment (ROI): A straightforward measure that calculates the percentage return on an investment relative to its cost. It is expressed as a simple ratio:

(Net Profit / Investment Cost) x 100

This metric is easy to understand and widely used because of its simplicity, but it doesn't take into account the time value of money or the duration of the investment.

Net Present Value (NPV): The value of cash flow taking into account the time value of money. For example, having $100 right now is worth more than receiving $100 one year from now. Why? Because if you have $100 now, you can invest it and earn a yield on your investment. So if you start with $100, then one year from now you might have $105 or $110 (or millions of dollars if you win the lottery!)

NPV discounts the value of future cash flow by assuming a discount rate of return on any invested capital. What that means in plain English, is that calculating the NPV of an investment tells you the present value of future cash flows.^[5] Generally speaking, if the NPV of an investment is positive, that investment is at least worth considering, as a positive NPV implies that future cash flows will yield more than current cash invested at the discount rate.

Ok, now that we have those definitions out of the way, let's dive into IRR.

Understanding IRR

IRR is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero.

That's a bit complicated, so let's break it down:

IRR is the annual rate of growth that an investment is expected to generate. It is calculated using the same concept as NPV, except it sets the NPV equal to zero. The reason we set the NPV to zero is because we’re trying to determine the discount rate which makes the present value of future cash flows equal to the initial cash outlay for the investment. Doing that will help us determine if the investment is expected to yield a positive return.

An easy way to think about IRR is through life insurance. Say you purchase a $100,000 life insurance policy at a cost of $10,000 per year (numbers are exaggerated for simplicity). If you were to die one year from now, this would be considered a worthwhile investment, as your beneficiaries would receive $100,000 in exchange for only one year’s payment of $10,000. The IRR on this policy would therefore be extremely high. But say you live 20 more years. Now you’ve paid out $200,000 into a policy that will only return $100,000–so your investment yields negative $100,000. That implies a negative IRR.

So should you invest in the insurance policy? One way to determine this is to find the IRR using different investment durations. This will help you understand which durations yield a positive return, and which a negative return. Then you can decide the likelihood of a positive return playing out vs. a negative one.

Calculating IRR can be extremely useful for investors who are considering making complex investment decisions that involve annuities, or reinvested dividends over time.

How is IRR Calculated?

Calculating IRR is super simple^[6]:

0=NPV= T C t
∑ —- - C0
t=1 (1+IRR)^t
​
Where:

Ct =Net cash inflow during the period t
C0 =Total initial investment costs
IRR =The internal rate of return
t= The number of time periods
​
That 'super simple' remark was actually sarcasm. The IRR formula is actually way complicated…

But don't fret, calculating IRR often requires the use of financial calculators or software, like Microsoft Excel. The formula is so complex because it has to take into account the time value of money, as well as the magnitude and duration of cash flows. A higher IRR suggests a more profitable investment (assuming all other factors are equal).^[7]

It's important to note that while IRR is a valuable metric, it can be misleading in certain scenarios, such as when cash flows are non-conventional or when there are multiple changes in the cash flow direction over time. This can result in multiple IRRs, which complicates the true rate of return determination. Additionally, IRR assumes that all cash flows are reinvested at the internal rate of return, which may not always be feasible in practice.^[8]

As a result, IRR should not be used as a standalone measure for investment decision-making. Investors should interpret the value of IRR alongside other financial metrics like NPV, payback period, and ROI to gain a more comprehensive understanding of an investment's potential. It's also crucial to consider the cost of capital and ensure that the IRR exceeds this cost to justify the investment. Remember, IRR is a rate of return–it does NOT quantify in dollars how much money an investment has made, which is why investors should also look at annualized returns and other performance measures to make more informed decisions.^[9]

IRR vs. ROI

When it comes to evaluating the performance of an investment, two of the most commonly used metrics are the IRR and ROI. Both offer valuable insights, but they serve different purposes and provide unique perspectives on an investment's profitability.

Let's dive into the differences between these two metrics:

As we already explained, ROI is a straightforward measure that calculates the percentage return on an investment relative to its cost. IRR is a more complex metric that calculates the annualized compounded return rate, and takes into account the time value of money.

ROI is more appropriate for simple investment decisions where the time horizon is short or when a quick, general comparison is needed. It's particularly useful for evaluating the profitability of one-time investments or projects with a clear and immediate return. ROI is also more commonly used when comparing different investment options or when evaluating the overall performance of a portfolio source.^[10]

Conversely, IRR is more suitable for complex investments involving multiple cash flows over time, such as real estate projects, capital budgeting decisions, or any investment where the timing of returns is a significant factor. It provides a standardized annual rate of return, making it ideal for comparing investments with different scales and durations. It's also beneficial when the investor wants to understand the investment's break-even discount rate, or when assessing the feasibility of achieving a particular target return.^[11]

Understanding both IRR and ROI can provide investors with a more comprehensive view of an investment's potential. For example, an investment with a high ROI might seem attractive, but if the IRR is low, it could indicate that the investment takes a long time to pay off or has uneven cash flows. Conversely, a project with a lower ROI but a higher IRR might be more desirable for investors seeking quicker or more consistent returns.^[12]

So while ROI provides a quick snapshot of an investment's profitability, IRR offers a more nuanced picture of an investment's profitability over time. By considering both metrics, investors can make more informed decisions that align with their financial goals and risk tolerance.

In Conclusion

While ROI is simpler and easier to calculate, IRR offers a more nuanced and comprehensive evaluation of investment profitability, especially for projects with longer durations and multiple cash flows.

The formula for calculating IRR is extremely complex–but widely available software and financial calculators can provide an IRR for you, given the correct inputs. Calculating IRR will help you understand an investment’s expected profitability, especially when long durations and multiple cash flows are part of the investment’s inherent features.

Private credit is one such investment. Determining the IRR of a private credit investment will help you gauge how well this investment is expected to perform relative to other investments you could make with the same capital. For example, many investment professionals now believe that private credit can produce a higher IRR than private equity over the coming years, given the relatively high discount rate.^[13]

Remember, IRR is a critical metric for evaluating the profitability of investments, but it must be used judiciously and in conjunction with other financial analyses to make the best investment decisions. Investors who understand the strengths and limitations of each metric can make more strategic decisions about portfolio diversification and risk management, ultimately leading to more informed and potentially more profitable investment choices.