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IRR - The Internal Rate of Return

  11/30/22 4:48 AM

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What is Internal Rate of Return?

IRR (The Internal Rate of Return) is a type of financial that estimates the expected return on investment. IRR is essentially the rate that makes an investment's Net Present Value (NPV) equal to zero. IRR is a helpful for comparing different investments. It — the greater the IRR, the greater the profit on investment.

How is IRR Calculated?

IRR incorporates the concept of Net Present Value (NPV) is the present value of all expected future cash flows from an investment in the present and future.

The Present Value (PV) of money is always greater than the future value of the same amount. This is because of the uncertainty present in the interim period, as well as price inflation, which reduces your purchasing power. Therefore, any Future Value (FV) of money must be "discounted," or reduced, at some discounting rate to arrive at its present value. On the other hand, any amount in the present does not need to be discounted.

When calculating IRR, a payment represents a negative cash flow (outflow). Similarly, receiving money denotes a positive cash flow (inflow). The NPV of the cash flow stream is obtained by adding these discounted cash flows at a specific rate, known as discounting rate.

IRR is the discounting rate that causes the NPV of a cash flow stream to be zero. In simple terms, IRR represents the interest rate at which your investment will be compounded to generate the maturity amount. Thus, the following IRR formula can be used:

What is the Benefit of using IRR for Your Financial Investment?

Using , one can compare the internal rates of return of various insurance plans with varying premium and payout amounts and frequencies. IRR is useful for evaluating investments with regular cash inflows or outflows. As a result, you can use IRR to estimate your returns from your SIP investments or regular income plans, such as:

IRR will assist you in estimating the actual return on your , which you can then compare to lump sum investments or other investments with annual CAGR (ompound nnual rowth ate) growth. Remember to convert your monthly IRR to a yearly rate of return before comparing it to CAGR.

It is not a financial tool, it is the rate of return used to calculate the profitability of investment made.

 

Siddhant Dubey - Writer & Photographer

Siddhant works as a freelance content writer who is interested in a wide range of spheres from photography and personal finance to cooking. He is also an aspiring photographer striving to showcase life around him through his vision. 

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