I have been delaying this post for quite sometime but I finally got hold of me. I have broken down this post into 3 parts and I discuss everything from from IRR to its nitty-gritties, its loopholes and the workarounds. I have written it in English so that even your kids can understand! Enjoy

**Part 1 – Contents**

- What is IRR ? (A complex and simple definition)
- A Case to explain the concept of IRR
- How to Calculate IRR (Simple math equation and by using Excel’s IRR function)
- Investing or Not Investing in the Business (Case Analysis)
- Interpreting Positive and Negative IRR

### What is IRR ?

If you googled ‘What is IRR’ you would get something like this –

**“ **Internal rate of return is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment **“**

Well, if the above definition sounds a bit overwhelming, I’ll give you a simpler one –

**IRR can be crudely understood as the maximum return achievable from the project**

Sounds fair enough? But I don’t want to leave you halfway, rather I really want you to understand IRR in real sense!

### Let’s take a look at this Case

Assume that you have an opportunity to invest in a business that is yielding the following cash flows

My simple question – **Would you invest ? **No Hurry, take some time to do your own math! What ever be your answer (Yes or No). The excitement lies in finding out WHY?

**Let’s do a bit of analysis**

- The business needs an upfront investment (-670) but the returns (1,134) come in 7 years from today. This brings me to a critical concept in finance
- Money today is more valuable than Money tomorrow (I am sure you know this). It is called Time Value of Money
- Because the cash returns are lying in the future you have to check that if the returns (1,134) are less or more than the your present day investment (-670) ?

- So the question is how much is 1,134 worth today? You obviously understood that we need a discount rate, but again
**what should be the discount rate**?

Instead of arguing about the discount rate, let’s figure out what could be a maximum discount rate.

Maximum means the discount rate should be such that the total cash flows earned over 7 years (1134) should be at least be equal to our present day investment (-670) So that we don’t make a loss on our investment

If you have understood everything till here then you know that I am trying to find out the **maximum discount rate which makes my Net Present Value **(Total Investment – Present Value of Cash Flows Earned)**=0**

Now when you read the definition from Google Search once again, it would make much more sense

**“ **Internal rate of return is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment **“**

The last line talks about attractiveness of the project, we are still to evaluate that. Let’s find the discount rate (IRR) first

### How to Calculate IRR ?

All you have got to do is to solve this equation

Or we could just ask Excel do it with the help of the **IRR function**

So if you discount the cash flows by ~14.5% they will result in a Present Value of 670 or Net Present Value of 0 (Investment – Present value of cash flows)

**The IRR formula **: Note the IRR formula has 2 parts

**Values :**These are the Cash Flows. It is mandatory to have positive and negative cash flows for excel to calculate the IRR**Guess :**For excel to start the IRR calculation it assumes a discount rate (default) of 10%. It is not mandatory to provide input for this argument. We will see more specific use of guess in the next part

### Should we invest in this Business?

We have not yet answered this question! But now we have done a bit of analysis to take a call.

**Case 1 : **Imagine that you have only invested in bank deposits which give you a return of 6% (assumption). So would you like to invest in a business which gives a maximum return (IRR) of 14.5% ? Ideally you should say YES!

**Case 2 : **Imagine that you have invested in equities before which gave you a return of 18% (assumption). Would you like to invest in a business which gives an IRR of 14.5% ? Definitely NOT! You would rather put them in your stocks.

Certainly this is not the most sophisticated piece of analysis but it does give you an idea about IRR

### Interpreting IRR when positive or negative !

**Case 1 : Negative IRR**

Note that IRR is negative. Think about this logically, you are investing -670 today for receiving 650 (which is less than your investment) over 7 years. This is stupid. It is because your Investment is more than your returns you have a Negative IRR*

**Case 2 : Positive IRR**

We have discussed the positive IRR example before, but lets do it again. Clearly you are receiving more than what you are investing, so a positive IRR

* Note that there could be other reasons of getting a negative IRR, which I will discuss in **Part 2 of this post**

### I am all ears to your Questions

Please put down your questions in the comments. I would love to know your feedback