Understanding IRR Calculation Logic

Equity Finance

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Understanding IRR (Internal Rate of Return) .

Definition :

IRR is the interest rate that makes net present value 0.

Usage :

  • IRR to be used of fixed periodic investments like in the case of mutual fund SIP  investments.
  • Absolute , Average and CAGR will provide incorrect results for periodic investments.
  • If the amount of periodic investment in different then XIRR should be used.

How to calculate IRR

Practical Example.

Assume every year you invest 1000$ , 3000$ in a mutual fund scheme for 3 years and at the end of the 3 year you receive 3500$ , 9800$ . If you wish to compare and identify the best investment strategy using IRR is the right strategy.

Cn : Amount for the period :  + for investment , - for amount received

n : Time duration in years

r : rate of interest. iterative value which is difficult to be calculated manually. 

 

In our example 

Case 1 : (8% calculated using Excel)

1000 / (1 + 0.08)*(1/12) +  1000 / (1 + 0.08)*(2/12) + 1000 / (1 + 0.08)*(3/12) - 3500 / (1 + 0.08)*(3/12)  = 0

Case 2 : (4% calculated using Excel)

3000 / (1 + 0.04)*(1/12) +  3000 / (1 + 0.04)*(2/12) + 3000 / (1 + 0.04)*(3/12) - 9800 / (1 + 0.08)*(3/12)  = 0

In the above example investment 1 is better than 2 using IRR.

 

Calculating IRR using Excel

calculating IRR using Excel is simple and easy

Note : IRR will return error if there is not + /- combination in the values

 

Calculating IRR using Python Code

https://erprealm.com/blog/irr-calculation-using-python-code/

 

 


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