Calculating an investment’s internal rate of reveals the minimum growth rate necessary to ensure that it does not result in a loss. The internal rate of return, or IRR, identifies the interest rate with which the net present value of an investment’s expenses or costs equals the net present value of its revenues or income -- in other words, the rate at which the net present value equals zero. The IRR can help you select mutual funds that provide the best investment value.
Identify the variables needed to calculate IRR. To calculate the IRR, you need to know an investment’s cash inflows and outflows for the investment period, the period of time of the cash flows and the interest rate for the period. The calculation of IRR is easier than other investment ratios because it assumes only one interest rate will apply to the investment period.
Identify the mutual fund you want to evaluate using IRR. Determine the fund’s expected cash inflows and outflows, the length of time you plan to hold the investment and the period’s interest rate. You will use these variables in your calculation. Calculating the IRR can be a complex endeavor. To simplify your analysis, use an online financial calculator or a spreadsheet template to calculate the IRR.
Compare the IRR of various mutual funds to determine the most suitable investment. Assuming all other investment factors for the funds under review are equal and the IRR is being used as the principal deciding factor, the investment with the highest IRR will be considered the best investment. The higher the IRR, the lower the investment risk and the higher the returns based on the costs involved.
- The IRR formula is very similar to the yield-to-maturity formula used in evaluating bond investments.
- Use of IRR is most effective when cash flows are similar for the investments under consideration and an initial cash outflow is followed by a series of cash inflows.
- Because interest rates change over time, its important to use care when evaluating an investment’s IRR because the resulting rate can provide information that can be misleading and result in the wrong conclusion.
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