IRR can be extremely useful because it can be utilized to compare different types of investments, even if they have different cash flows, capital requirements, and timelines. Analysists use a metric called internal rate of return (IRR). IRR calculates a kind of “reverse interest rate” called the discount rate, which makes the net present value (NPV) of all cash flows zero. Another way to say it is that IRR calculates the rate of your investments growth considering the timing of future cash flows. In doing so, IRR takes into account the time value of money.
Suppose someone promises to pay you $100,000 in 12 months for interest on a $1,000,000 loan. You should consider the fact that $100,000 in 12 months is worth less than $100,000 right now. If you had it now, you could lend it out at 10% APR and have $110,000 in 12 months. The rate of 10% is an example of the time-value of money.
IRR is calculated by a mathmatical operation that requires resolving a cumbersome series of numbers through trial and error. Fortunately, spreadsheet apps like Microsoft Excel or Google Sheets make it easy to calculate IRR.
Sample Using Excel:
You need a cell on the spreadsheet for every year of the investment, plus cells for each annual cash flow. For a five-year investment, you need 7 cells. We will use row “1” horizontally
A1: Total cash invested. (This includes the down payment, all closing costs, and immediate cash outlay for repairs and deferred maintenance) IMPORTANT: This cell, and only this cell, will contain always contain a negative number because it is an outflow of money. Should you have losses in cash flow, those can also be negative.
- B1: Cash Flow, Year 1
- C1: Cash Flow, Year 2
- D1: Cash Flow, Year 3
- E1: Cash Flow, Year 4
- F1: Cash Flow, Year 5 + Gross Sale Proceeds (don’t subtract the cash invested—this should be every dime you pocket at closing when you sell)
- A2: =IRR(A1:F1)
IRR is a great tool to know how to use. However, you must also know how it can be a big disadvantage. Read this article to know more. The Problem With IRR Led Investment Strategies.