Internal Rate of Return Explained
Internal Rate of Return (IRR) is a more complex metric used for evaluating investments, and unlike equity multiple, it adds in the variable of time.
For example, if you invest $50,000 into a syndication and receive $100,000 plus your initial capital investment, that seems like a great investment. But would it still be an excellent investment if it took 20 years to get that return? Wouldn’t it be a better investment if it only took five years?
Think of IRR as the expected annual growth rate of an investment. It allows you to factor in time when evaluating projected returns. What makes IRR highly useful is that it can be used to compare different investments across various asset classes. For example, you can use IRR to compare an investment that is expected to last ten years with another that is expected to last just three years.
Importance of IRR in an Investment Decision
IRR is a useful tool for evaluating the potential profitability of an investment, as it provides insight into the rate of return that an investor can expect to receive from the investment. Ultimately, a higher IRR implies a more attractive investment opportunity, as it indicates that the investment is generating higher returns relative to its cost of capital.
Calculating IRR
From a mathematical perspective, IRR is a financial metric used to calculate the rate at which an investment will generate a net present value (NPV) of zero. In other words, it is the discount rate at which the present value of cash inflows equals the present value of cash outflows. The formula to calculate IRR is complex and best done using Excel or Google Sheets.
If you want to learn how to calculate this metric yourself, we recommend Investopedia for a detailed guide on how to calculate an internal rate of return.
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