When embarking on a new endeavor or investing in development to increase revenue or cut down costs, a company will determine the annualized IRR before committing. Both monthly and annual IRR analyze various investments, especially under the circumstances with multiple cash investments.
What Is IRR?
IRR stands for internalized rate of return. According to the U.S. Securities and Exchange Commission, it is the annualized effective compounded rate of return of an investment, accounting for money's time value and expressed as a percentage. Essentially, an annualized IRR is the expected annual rate of return on an investment or project.
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More often than not, taking on a new project requires investing in development. When a company decides to either cut down on costs or increase their revenue by developing a new project, they will research the return on the investments to gauge whether it's worth taking on and how to prioritize projects.
Internal rate of return is most commonly used when analyzing investments in private equity and venture capital, Corporate Finance Institute writes. It's particularly advantageous in situations with multiple cash investments over a business's life as well as cash flow through an IPO or business sale. After determining the IRR, it is compared to the company's minimum acceptable rate of return (MARR), also known as the hurdle rate, to determine whether the project is a viable investment. However, the MARR is not the only metric a company considers before investing.
Calculating Internal Rate of Return
To calculate annualized IRR, the cash investment for the beginning period will equal the present value of future cash flow, making the net present value (NPV) equal zero. According to Corporate Finance Institute, the NPV is the value of all future cash flows over the investment's life, discounted to the present and expressed as either a positive or negative value.
Consider also: How to Calculate IRR in Banks
To perform the calculation for annualized IRR, one would need to know the initial investment and the cash flows for each period. Calculating the internal rate of return can get complicated, so it's typically recommended to calculate it using the IRR function in Excel. However, it's essential to note that the IRR function in Excel assumes equal time periods, meaning it ends the following year on the same month it started. If you require flexibility in the time period, use the XIRR function in Excel instead, which allows you to manually input the time periods you wish to use in the equation.
When using either IRR function in Excel, the resulting value is an annual rate of return. According to Ablebits, you can calculate the monthly internal rate of return by using the XIRR function in Excel. First, calculate the annual internal rate of return by inputting the cash flow beside the corresponding date. Once you have the annual XIRR value, input it into the following equation: (1 + Annual XIRR)(1/12) - 1.
Converting Monthly to Annualized IRR
Essentially, the annualized IRR is the amount of money made when the monthly internal rate of return continues each month for a year. To convert a monthly IRR to annual IRR, use the formula above, except instead of raising to the power of 1/12, you will raise to the power of 12: Annual IRR = (1 + Monthly IRR)12 - 1.
For example, suppose the monthly IRR is 5 percent. The calculation will go as follows: (1 + .05)12 -1 = 79.59 percent.