Internal Rate of Return

IRR Full Form in English, letter by letter

IRR is the Internal Rate of Return, the discount rate at which the net present value of an investment's cash flows becomes zero.

IRR Full Form in Indian Languages

IRR is the number managers and investors compare first when two projects compete for the same money. It stands for Internal Rate of Return, and the name is given below in six Indian languages.

How the Internal Rate of Return is defined

The IRR full form is Internal Rate of Return. It is the discount rate at which the net present value (NPV) of all the cash flows of an investment becomes zero. In plain terms, it is the yearly return that the investment is expected to earn over its life, taking the timing of every cash flow into account.

Take a small example. If you pay Rs 1,000 today and receive Rs 1,100 in one year, the IRR is 10 per cent, because discounting Rs 1,100 back at 10 per cent gives exactly Rs 1,000. With a longer series of cash flows there is no simple formula, so the rate is found by trial and error, with a financial calculator or with the =IRR() function in Excel.

A second example shows why timing matters. An investment of Rs 1 lakh that returns Rs 40,000 a year for three years has an IRR of about 9.7 per cent. If the same Rs 1.2 lakh came back in a lump sum after three years, the IRR would be about 6.3 per cent, even though the total received is the same. Earlier cash raises the IRR.

Because IRR is a yearly percentage, it lets you place a factory expansion, a rental flat and a mutual fund SIP on the same scale. That is why capital budgeting committees ask for it.

The IRR decision rule and where it breaks

The standard rule is to accept a project when its IRR is higher than the cost of capital (the weighted average cost of capital for a company, or a hurdle rate set by an investor) and to reject it otherwise. For a single project with conventional cash flows, an outlay followed by inflows, IRR and NPV give the same verdict.

They can disagree when projects are mutually exclusive and differ in size. A Rs 5 crore project with an IRR of 22 per cent adds less value in rupees than a Rs 50 crore project at 18 per cent, so choosing the higher IRR can mean giving up the bigger NPV. IRR does not see scale.

There are two more traps. If cash flows change sign more than once, for example when a large decommissioning cost arrives at the end, there can be several IRRs or none. And IRR implicitly assumes that interim cash is reinvested at the IRR itself, which is optimistic when the IRR is 35 per cent.

Where Indian finance teams use IRR

Companies use it in capital budgeting: each capex proposal is usually scored on NPV and IRR together. Banks and NBFCs examine a project's IRR before sanctioning a term loan, along with the debt service coverage ratio, to see whether the cash flows can carry the interest.

Private equity and venture funds quote gross and net IRR to investors. A headline IRR of 25 per cent over a five-year hold is a fundraising figure, and the timing of exits matters as much as the exit price. Real estate developers run a project IRR to compare a residential launch with a commercial one.

Infrastructure projects are appraised the same way. The authority inviting bids usually checks a project's expected return against a benchmark before approving it, and these figures appear in the financial annexures of the bid.

Individuals meet IRR when they compare a life insurance policy with a fixed deposit. The maturity benefit of an endowment plan, divided over the premiums paid year by year, gives an IRR that can be placed against an FD rate. Insurers do not always state it, but you can compute it in Excel from the policy illustration.

IRR versus NPV, XIRR and MIRR

NPV answers a question that IRR cannot: how much wealth, in rupees, the project adds. Because of the reinvestment assumption and the ranking problem, most finance textbooks prefer NPV when the two disagree. MIRR (modified IRR) is a common compromise that forces a realistic reinvestment rate.

XIRR is a related Excel function that takes actual dates, so it suits irregular investments, such as SIP instalments made on different days. Many mutual fund apps show XIRR for that reason. IRR assumes equal gaps between cash flows.

A #NUM! error in Excel usually means the cash flows never change sign, or that no solution was found from the starting guess. A negative IRR is not an error. It means the project loses money at any positive discount rate.

Finally, IRR is a relative number. Two investments can both show 15 per cent and still be very different opportunities if one is Rs 10,000 and the other Rs 1 crore. Read it together with the size of the cash flows and the NPV.

IRR condenses a project's whole cash flow into one percentage. It is useful, but it is best read next to NPV and the size of the investment, and never as the only number.

IRR Full Form: Common Questions