How is Internal Rate of Return Calculated in Mutual Fund?

As an investor, we often indulge in initial cash outlay for the expected future benefits arising out of the assets. The core aspect of an investment is to evaluate and find assets that are in line with the wealth maximization goals of a person or a company. The phrase evaluating and finding assets holds quite a key to unlocking the door to a fruitful investment. But how do you quantify the evaluation?This is where various financial analysis tools come into play. Internal Rate of Return (IRR) is one of those financial analysis tools used by all investors, companies, and business owners. Find out how IRR holds the key to the right investment decision making and how it can be calculated down below:

Internal rate of return (IRR) is a discounted rate that equates the present value of cash inflows to the initial cash outflow. It can also be considered as the annual growth rate that the investment is likely to generate further. It considers the factors like time value of money, initial cash outflow, and all cash flows arising during the assets' lifetime. Part of capital budgeting, it is one of the vital criteria for investment decision making.

You can calculate IRR with the help of a formula. The commonly used formula to calculate IRR is: NPV= CF1/(1+ r)1 + + CF2/(1+ r)2+ CF3/(1+ r)3+ ……… + CFn/(1+ r)n - CF0 WhereCF0 = Initial Cash OutflowR= Discounted RateN= Time PeriodThe common method is to replace NPV with zero and calculate the internal rate of return. But the scenario is much different than it seems. Since the formula is articulate, you need to calculate it analytically and use the trial and error method to reach the required discounted rate. Let's take this case as an example.ABC Limited is evaluating a project that will involve an initial outlay of Rs 1 lakhs. The project will derive a cash inflow of Rs 25,000 for 6 years. The salvage value of the project is zero. If the company invests the money in another instrument or option, it will fetch a 10% return.The computation of the same can be done using the above formula, or you can also use the IRR function in MS Excel to reach out for the result. However, we will be following another way of solving the same manually with trial and error. The below-mentioned method utilizes the present value annuity factor and the interpolation formula to solve the same.

• Step 1:Payback period of the investment Payback period = Cash outflow/ Annual expected cash flow = 4Using the present value annuity table for year 6, the numerical value of 4 falls between 3.998 and 4.1111. The corresponding discounting rates for these are 13% and 12%. Therefore the IRR would be between 12% and 13%.
• Step 2: Using NPV formula (NPV = Cash outflow – Cash inflow) NPV(12%) = 100000 – (4.1111*25000) = 2775NPV(13%) = 100000 – (3.998*25000) = (50)
• Step 3: Using Interpolation technique IRR = LR + [NPV@LR/ (NPV@LR-NPV@HR)] * (HR-LR)= 12% + 2775/ 2775 – (50) * [13% -12%]= 12.98%Using the interpolation technique, the internal rate of return is 12.98%. If you look at the example, ABC would have fetched a return of 10% if they would have invested elsewhere. In comparison, this project seems viable.

• IRR vs Compound Annual Growth Rate (CAGR) Compound Annual Growth Rate is a widely used financial analysis tool. But therein lies a catch. It uses only the beginning and the end value of the investment to calculate the annual return. IRR, on the other hand, measures return based on periodic cash inflows. This is why many investors use IRR along with CAGR to derive a conclusion.
• IRR vs Return on Investment (ROI) Return on investment looks into the aspect of the investment's total growth, ranging from start to finish of the period. Unlike the IRR and CAGR, this is not an annual growth rate. It is computed by taking the difference between an investment's current value and its cost and dividing the same by the investment cost. It is expressed in terms of ratio or percentage. But ROI figures cannot provide detailed, articulate details like IRR.

IRR is one of the parameters that can be used for the judgment and evaluation of a project. Business owners and companies use it as part of their capital budgeting procedure. However, the same can be used by investors alike for comparing and picking the right investment choices.As is the rule of internal rate of return, if the project provides a higher yield than that of the required rate of return or capital cost, the investment choice seems financially feasible to invest into.However, it also comes with a few limitations as the percentage is based on estimated cash inflows, and the actual figures may vary with time. Use IRR, along with other financial analysis tools, to reach conclusive evidence.IRR is one of the most important tools you should know about when it comes to financial analysis and decision making. The use of time value of money factors estimated cash inflows for the investment period and more to provide a detailed briefing of the investment.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.