Calculating IRR - Internal Rate of Return

Internal Rate of Return (IRR): An Overview

While investing in insurance or any financial product, the first thing an investor needs to be aware of is its internal rate of return, known as IRR. IRR is a financial measure that determines the expected return or profitability of the investment. But what is the formula of IRR? How do we calculate IRR? What is the significance of IRR in insurance?

This article discusses the core concepts of IRR, its relevance to investors, methods to calculate IRR, and its real-world applications.

What is IRR Full Form and IRR Definition?

Internal Rate of Return (IRR) is a metric used for capital planning by investors. IRR aids in comparing potential investments by quantifying their internal profitability, allowing for a more informed decision-making process.

By calculating IRR, the investor determines the annual discount rate, meaning that the net present value of the investment equals zero. The higher internal rate of return (IRR) reflects the higher investment profit.

In short, the IRR is the expected return rate when the net present value (NPV) of cash investment during an investment period equals the present value of cash profits. In the insurance industry, the IRR value ensures that the loss of liquidity during the investment period is worth it.

“IRR serves as a comprehensive indicator, considering the time value of money and providing a percentage representing the internal profitability of an investment.”

Key Points to Know About Internal Rate of Return (IRR)

When the investors are trying to find out and compare investment options with some related characteristics, the investment with the highest IRR is preferred in the first place.
The calculation of IRR is the same as NPV, except that IRR sets the NPV equal to zero.
Internal rate of return (IRR) is used to analyze capital budgeting projects to get a clear picture of potential annual return rates over time.
In a company, the calculating IRR helps identify which capital project to use for investment.

How do You Calculate the Internal Rate of Return (IRR)?

Before calculating IRR, let’s understand the basic terms to simplify the calculation. Suppose you have bought insurance or want to invest in any project.

When you pay an amount or a premium in the name of the policy, it stands for a negative cash flow, known as outflow.

Similarly, when you receive an amount or a payout/ benefit after a certain period, it is known as the positive cash flow, called inflow.

When you apply a discount on these cashflows at a definite rate and add them up, you get the Net Present Value. IRR (Internal Rate of Return) is the discounting rate which sets the NPV of a whole cashflow stream (outflow + inflow) to zero.

NPV = 0 = Present value of negative cash flow + Present value of positive cash flow

To calculate the internal rate of return, you can use the given methods:

Use the financial calculator available online to calculate the IRR value.
With IRR Excel method.
Pen-paper method

IRR Calculation Using Finacial Calculator

To calculate the IRR value online using a financial calculator, you must provide an estimated value of the investment you plan to make and year-wise cash flow. Follow the given steps to calculate IRR

Open the IRR calculator available online.
Enter the initial investment amount and year-wise investment cash flow in chronological order.
Click on the ‘calculate’ button.
The calculator uses the basic calculation formula and reflects the estimated internal rate of return for your investment.

IRR Calculation Excel

Follow the given steps to use IRR in Excel formula to calculate IRR rate of return.

Enter your investment cashflow stream in a table. Make sure the list is in chronological order.
Clearly determine the investment period. This investment period specifies the number of cashflows.
Calculate the interest rate per period.
Use the IRR formula in Excel, which you can find by clicking on the formula insert (fx) icon to calculate the Internal Rate of Return.

A positive IRR indicates that your investment in a plan generates a return greater than the interest rate. While a negative IRR represents that your investment generates a return less than the interest rate.

Compute IRR Using Pen-Paper Method

Use the given is the formula to calculate the IRR (internal rate of return) manually

IRR = [∑(CFn * (1 + r)n)]/∑(CFn)

Where;

CFn = Cash flow for period n

R = Rate of return

N = Number of cash flows

While using the above equation for IRR, remember that

You arrange the cashflows in increasing order (negative to positive).
Calculate the cumulative cash flow.

How to Use IRR Calculation Formula for Insurance Investment?

Say you have bought an insurance plan. The premium you pay is called the negative cash flow, and the payouts you are supposed to receive at a definite period are called the positive cash flow. Below, we mention an IRR rate of return example

Ramesh buys X (life insurance or any other investment) plan. He pays a lumpsum premium of Rs. 10,000 and receives two payouts: Rs. 5,250 after one year and Rs. 5,512 after two years of investment. Hence,

Negative cash flow (outflow) = Rs. 10,000 (not discounted since it is at present)

Positive cash flow (inflow) = Rs. 5,250 + Rs. 5,512 (need to be discounted since it is in the future estimate)

NPV = 0 = – PV of Rs 10000 + PV of Rs 5250 + PV of Rs 5512 = – 10000 + 5250 / (1 + IRR) 1+ 5512 / (1 + IRR) 2

The estimated IRR in the above example will be 5%.

* The above example is just a representation of how you can calculate the IRR.

You can use the IRR in Excel or pen-paper method and compare different insurance plans to calculate the estimated IRR return value for different premiums and frequencies.

Understanding the Difference Between IRR and ROI

Return of Investment (ROI) helps the investor to measure the total growth of the investment, from start to finish. Investors can easily assess the annual growth rate using the given formula IRR internal rate of return.

IRR = Current/ Future Expected Value – Beginning Value / Original Value X 100

ROI is an exceptional tool to measure the outcome of every investment within a year. However, the ROI isn’t that helpful for long-term investments. Meanwhile, the IRR is the expected compound annual rate of return on any investment.

Investment Based on IRR

The IRR internal rate of return provides a guideline to help investors evaluate whether to proceed with investment in a project or not. Per the IRR rule, if the IRR in a project is greater than the cost of capital, the project or investment can be considered.

On the other hand, if the IRR return is lower than the cost of capital, you can consider dropping your investment.

Limitations of IRR

If you only go with the numbers, say an IRR of 30%, you cannot identify if it’s the IRR of 30% for 10,000 or IRR of 30% for 1,00,000. Hence, if you compare two projects only by measuring the IRR, the investment decisions may be highly affected.

Another important point about IRR is that it assumes all the positive cash flows of the project will be reinvested at the same rate as the project. It totally neglects the cost of capital of the company.

Final Words

When you buy an insurance policy with any life insurance company, IRR is an important tool to judge your investment with regular outflows and inflows. Use the IRR formula to estimate your returns from regular investment plans like

Unit Linked Insurance plans
Mutual Funds SIPs
National Pension Schemes

We have mentioned IRR formula and IRR calculation methods useful for the investor while buying an insurance policy from any life insurance company. While investing in a company project, calculating IRR return help invest their capital strategically.

For a better understanding, we suggest you connect with a financial advisor who can help you evaluate the IRR and ROI of your investment and increase your return over a year.

IRR Related FAQs

What is IRR in simple terms?

In simple terms, the IRR stands for internal rate of return, which is the discount rate that turns net present value (NPV) of an investment equal to zero. The IRR helps an individual in capital budget calculation and decide which project or investment is worthwhile and ranking them.

What are the issues associated with IRR?

The internal rate of return (IRR) underestimates the actual dollar value of comparable investments. It does not take into account the negative cashflows.

When do you know if IRR is acceptable?

If the IRR value is greater than or equal to the hurdle rate (the minimum required rate of return), then it is acceptable.

When should the IRR not be used?

IRR (internal rate of return) should not be used to compare projects of different duration since it doesn’t consider the cost of capital.

Why does IRR decrease over time?

Since IRR measures the total return over time, it considers the time value of money. Long-term investments decrease the IRR. Hence, it is advisable to calculate the internal rate of return for shorter investments.

What is the difference between NPV and IRR?