What is Internal Rate of Return in Mutual Fund?

Internal Rate of Return (IRR) is one of the commonly used financial tools in the field of finance and investments. This is something that you may hear or read around plenty in the market. And there's a reason for that. IRR is one of the vital parameters to help define the investment decisions and seek feasibility of the returns for a project or an investment.Whether you're an individual or a company, IRR helps evaluate the commercial viability of the projects helping you make important decisions. After all, investments aren't something that you should do in a bluff, isn't it? Find out more down below.

• Discounted Rate: It is a term used in Discounted Cash Flow Analysis and refers to the interest rate used in determining the present value of future cash inflows.
• Discounted Cash Flow Analysis: It refers to the cash flow analysis using the discounted return rate where the present value of the future cash flows is calculated.
• Net Present Value (NPV): It refers to the present value of any future cash inflows arising from the investment. It is based on the concept of the time value of money, where future cash flows are converted into a present-day value with the help of the discounted rate.

Internal rate of return (IRR) is one of the metrics used extensively in financial analysis. It's part of the capital budgeting techniques that allow you to gauge and seek the investment's financial workings and the returns arising from it. It's a discounted rate, where the net present value (NPV) of the investment becomes zero and is expressed in terms of percentage. In simple terms, this means a stage where the discounted cash inflows arising out of the investment are equal to the project's total cash outflows.

As discussed, IRR is a discounted rate where the net present value of the project is zero. This helps a company or an individual understand the return rate that will be derived if the company is to invest their money.The IRR computed therein is compared to the cost of capital or required rate of return to see if the project is viable. To put it simply, if the IRR exceeds the required rate of or return or the cost of capital, then it's financially feasible to go for it. Here's an example for the same:

• ABC Company is considering the purchase of new machinery to help increase sales. The machinery's cost is Rs 5 lakhs, and the machine is expected to generate an additional profit of Rs 2,50,000 per annum for five years. The salvage value of the machinery at the end of five years is zero. If the company invests the same amount in other instruments or options, it will fetch a 14% return.

Assuming the scenario, IRR will be 20.11%. This is significantly higher than the required return rate, and the investment is financially feasible to make.

• Use of Time Value of Money IRR uses the concept of the time value of money to calculate project feasibility or investments. Since the future cash inflows will be less in value due to inflation, the time value of money allows it to be interpreted in terms of present value. This helps IRR in calculating the accurate present value of the investment.
• Simple to use and understand Unlike other financial analysis tools, the Internal rate of return is simple to use and understand. It can be used by any common person or small business owner to gain a quick snapshot of how the investments would perform and yield over the period. Just compare it with the required or prevailing rate of return, and you'll know whether to go with the investment or not.
• Helps in decision making How would you compare two projects and find the right choice when it comes to investments? IRR can do that with ease for you. It is one of the trusted parameters for comparing two or more investment options to find the right pick.

IRR takes into account certain assumptions where the investment is assumed to grow at a similar rate annually. This can be used to calculate the returns on mutual funds investment similar to that of the use of Compound Annual Growth Rate (CAGR).However, periodicity and the project's scale may vary, resulting in a varied IRR from the estimated one. That being said, any project with an internal rate of return that exceeds the prevailing rate of return is likely to return profits for the investor and be a good investment.IRR is one of the vital parameters for determining the feasibility and the scope of return from your investment. It is simple to use and can help make investment decisions easily rather than going through plenty of financial and technical analysis.

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.