Internal Rate of Return (IRR) – Meaning, Calculation & Advantages
In the world of finance and investments, very often you hear the term IRR or internal rate of return. Many a time, company officials make announcements of going ahead with a project because it is financially viable. A company uses a variety of financial tools and metrics to evaluate the commercial attractiveness of a project to make its operating and investing decision. One of such vital parameters to determine the attractiveness of the project and whether or not a company should invest its resources in it is by calculating the internal rate of return, or IRR of the project.
What is the Internal Rate of Return (IRR)?
Internal rate of return (IRR) is a capital budgeting technique to gauge the performance of an investment and the help determine its profitability. IRR is expressed as a percentage, and it is the discount rate at which the net present value of an investment or project becomes zero. IRR takes into account the time value of money and capital inflows and outflows over the life of the investment. As the full form of IRR suggests, it is the internal rate of return and does not take into account external factors like inflation, state of the economy, etc. at the time of calculating returns.
In simple terms, IRR is the breakeven rate of a project. If the IRR of a project is high and exceeds the required rate of return, then the company will go ahead and invest in the project, but if the IRR is low and below the required rate of return, then the company will not go ahead with it. It also helps analyze and compare between different projects and how to prioritize projects based on their IRR.
How is IRR calculated?
Calculating the IRR of a project is not a straightforward calculation. It requires trial and error as we try to arrive at a percentage wherein the net present value of the investment will become zero. IRR of a project can be easily calculated through financial calculators or using the IRR function in excel.
The formula for IRR is
0= P0 P1(1 IRR) P2/(1 RR)2 P3/(1 IRR)3 P4/(1 IRR)4 ... Pn/(1 IRR)n
Where P0, P1 ... Pn are the cash flows in the period 1, 2, .., n, respectively and IRR is the internal rate of return of the investment.
Here is an example to show how to calculate IRR-
A company is considering the purchase of machinery to increase its sales, whose cost is Rs 3,00,000. This new machinery has a life of three years, and it will help the company generate an additional profit of Rs 1,50,000 per annum in the three years, and the scrap value, in the end, is Rs 10000. The company’s rate of return from investing the cash in other investments will fetch a return of 15%. Now, if we want to find out if buying the machinery is a better option or not, we have to calculate IRR.
0 = -Rs 300,000 (Rs150, 000)/(1 .243) (Rs150,000)/(1 .2431)2 (Rs 150,000)/(1 .2431)3 Rs10,000/(1 .2431)4
The net present value of the investment becomes zero when the IRR assumed is 24.31% which is much higher than the required rate of return of 15%. Thus, the company must purchase the machinery.
What are the advantages of using IRR in investments?
There are many advantages of using IRR technique at the time of analyzing investments and include-
- Time Value of Money is considered
One of the significant benefits of using the IRR technique is that it takes into account the time value of money at the time of calculating the returns from an investment. This makes IRR credible and accurate to determine the future earning potential of the money
- A simple technique for analysis
Using the IRR technique to assess the profitability of the project is straightforward. If the project IRR is higher than the cost of capital or required rate of return, then it is advisable to go ahead otherwise not.
- Helps rank and compare projects from an investment perspective
When you have to make a comparison between two or more projects, IRR is useful in comparing and ranking projects depending on the yield. The project with a higher IRR is preferred.
Limitations of IRR technique
Even though IRR is an important financial metric in capital budgeting, it has its limitations. The major drawbacks of using IRR technique are-
- Project duration, size, etc. not considered
One of the most significant disadvantages of IRR is that it does not take into account important aspects such as the scale of the project, time taken for completion, etc. into account at the time of comparing projects, which can be misleading.
- The assumption about the reinvestment rate
Another limitation of using the IRR technique is that it assumes the same reinvestment rate for all the future cash flows throughout the tenure of the project, which is not practical as not all the future cash flows may have the same reinvestment opportunity.
One of the best ways to overcome the limitations of IRR is that one should not use IRR in isolation but use the NPV method and IRR together in capital budgeting to understand the profitability of the project. Another option is to use the MIRR, which is the modified internal rate of return, which helps overcome the assumption of reinvestment at the same rate.
Conclusion
IRR plays an important role in determining the return from your investments, and if you want to use IRR in practice, then open a Demat account with IndiaNivesh and get the correct guidance from our experts to get desirable returns on your investments.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
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Financial Markets - Overview, Structure, and Types
What is Financial Market? A market is defined as a place where goods and services are bought and sold. Along similar lines, a financial market is one where financial products and services are bought and sold regularly. Financial markets deal in the purchase and sale of different types of investments, loans, financial services, etc. The demand and supply of financial instruments determine their price, and the price is, therefore, quite dynamic. Financial markets form a bridge between investors and borrowers. It brings together individuals and entities that have surplus funds and those who are in a deficit of funds so that funds can be transferred between them. This transfer of funds is done through different types of financial instruments that operate in the financial markets. Structure of the Indian financial market The Indian financial market is divided into two main types – the money market and capital market. The capital market is further sub-divided into different types of financial markets. Let's understand – Let’s understand each type of financial market in details – Money market The money market is a marketplace for short-term borrowing and lending. Securities that have a maturity period of less than a year are traded on money markets. The assets traded in money markets are usually risk-free and are very liquid. Since the maturity period is low, the risk of volatility is low, and the returns are also low. Money market instruments are debt oriented instruments with fixed returns. Some common examples of money market instruments include Treasury Bills, Certificates of Deposits, Commercial Papers, etc. Capital market Contrary to the money market is the capital market, which deals in long-term securities. Securities whose maturity period is more than a year are traded on the capital market. Capital market trades in both debt and equity-oriented securities. Individuals, companies, financial institutions, NRIs, foreign institutional investors, etc. are participants of the capital market. The capital market is divided into two sub-categories which are as follows – Primary market Also called the New Issue Market, the primary market is that part of the capital market, which is engaged in the issuance of new securities. The newly issued securities are then purchased from the issuer of such securities directly. For instance, if a company offers an IPO (Initial Public Offering) and sells its shares to the public, it forms a part of the primary capital market. Investors directly buy the shares from the company, and no middlemen are involved. Similarly, if an already listed company issues more shares, called Follow-on Public Offerings (FPO), such shares can be bought by investors directly from the company. Secondary market The secondary capital market is where the securities bought in the primary capital market are traded between buyers and sellers. Stock trading is a very common example of a secondary capital market wherein investors sell their owned stocks to interested buyers for a profit. A secondary market is characterised by an intermediary and the trading of securities takes place with the help of such intermediary. While securities in the primary market can be traded only once, securities in the secondary market can be traded any number of times. The stock exchange is a part of the secondary market wherein you can trade in stocks of different companies that have already been offered by the company at an earlier date. Other types of financial markets Besides the above-mentioned types of financial markets, there are other types of financial markets operating in India. These include the following – Commodity market This market deals in the trading of a commodity like gold, silver, metals, grains, pulses, oil, etc. Derivatives market Derivative markets are those where futures and options are traded. Foreign exchange market Under a foreign exchange market, currencies of different countries are traded. This is the most liquid financial market since currencies can be easily sold and bought. The rate fluctuations of currencies make them favourable for traders who look to book profits by buying at a lower rate and selling at a higher one. Bond market Bond market deals in trading of Government and corporate bonds, which are offered by Governments and companies to raise capital. Bonds are debt instruments that have a fixed rate of return. Moreover, bonds also have a specific tenure, and the bond market is, thus, not very liquid. Banking market The banking market consists of banks and non-banking financial companies which provide banking services to individuals like the collection of deposits, the opening of bank accounts, offering loans, etc. Financial market and services The services offered by financial markets today are as follows – They provide a platform for buyers and sellers to trade on financial products The financial market determines the price of financial instruments traded on it. This price is based on the demand and supply mechanism of the instrument and can move up and down frequently The market provides liquidity to investors when they need to sell off their investments for funds The market provides funds to borrowers when they need financial assistance The Indian financial market is influential in the economic growth of India as a whole The financial market helps in mobilization of funds from investors to borrowers Thus, the financial market and its services are varied, and that makes the financial market an important component of the Indian economy. Regulators of financial markets Financial markets and services offered by them should be regulated so that the participants of the market follow the laws of trading. As such, there are different regulators of the market that ensure that all participants trade fairly. These regulators are as follows – Reserve Bank of India RBI is the regulator for banks and non-banking financial companies. It is the central bank of India entrusted with the formulation of monetary policies, credit policies, and foreign exchange policies, among others. Banks and financial institutions have to abide by RBI's rules and regulations to work in the financial market. Securities and Exchange Board of India SEBI is the primary regulator of the capital market, which consists of both the primary as well as the secondary capital market. Trading done in the capital market is governed under SEBI's rules and laws. Insurance Regulatory and Development Authority IRDA governs the rules and regulations which are to be followed by insurance companies and their intermediaries. Thus, IRDA is a regulator of the insurance market, both life, and general insurance market. Financial markets today have evolved and have become quite competitive with the participation of multiple players. They directly play a part in the growth of India's economy and allows investors and borrowers to trade in financial products and services in an easy and smooth manner. To take advantage of the Financial markets and varied investing opportunities, consider the team at IndiaNivesh, which is well-versed with types of markets and regulatory bodies. Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
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What Is a REIT (Real Estate Investment Trust) & How it works?
What is REIT? A well-diversified portfolio is important to achieve optimal returns on your investments and also minimize the overall risk of your investments. To create a balanced portfolio, it is important to invest in various asset classes that have a lower correlation to each other. A majority of investors today have a healthy mix of stocks, bonds, and gold in their portfolio for the same reason. Real estate, too, is an important asset class for a well-diversified portfolio as it has a very low correlation to stocks and bonds. However, even though, investing in real estate can be rewarding, not many investors have exposure in real estate primarily because real estate investments, especially, commercial real estate require huge capital that is financially out of reach for retail investors. REIT investments provide the perfect opportunity for such investors to diversify real estate and create an additional avenue of growth and income from their portfolio without actually owning any real estate properties. What is REIT? REIT or real estate investment trusts are securities that trade in real estate properties. REITs are companies that own, manage or operate income-generating real estate properties and provide investors with the opportunity to invest in these real estate assets that are otherwise out of their financial reach. REITs invest in commercial spaces like offices, shopping complexes, multiplexes, hotels, etc. and create a steady source of rental income through these investments. In a simple definition, REITs can be considered as a mutual fund of real estate, wherein investors buy shares of REIT and contribute money to a pool of funds that are professionally managed and invest the money in income-generating properties. Just like mutual funds REITs have a three-tier structure of having a sponsor- who has the onus to set up the REIT, a fund management company for selecting and operating the properties and a trustee to safeguard the interest of the unitholders. REIT investing provides an opportunity for investors to earn regular returns from the rentals and leasing income of the trust and also long-term gains by way of capital appreciation of the underlying real estate. How does a company become eligible for REIT? A company is not eligible as REIT only because it owns some real estate. Here are some specific requirements which it needs to fulfil to become eligible for REIT-: REITs must have an asset base of Rs 500 crores REITs must distribute 90% of their profits as dividends to the unitholders REITs must invest 80% of the funds in real estate that is generating income, and only 20% can be invested in under-construction properties REITs must update their NAV twice in a year How does real estate investment trust work? The real estate sector has immense potential in India and as the government is continuously working towards creating world-class infrastructure and development of the real estate. As quality properties are high on investment so they are potentially out of reach for the common man. However, investments in REIT funds enable investors of varying financial capacity to invest in the real estate sector and participate in the growth and development of the real estate and earn profits from their investment. REIT funds are the perfect gateway for investors to invest in high-quality real estate assets by making them affordable and within their reach. Broadly speaking there are three types of REITs which currently operate in India Equity REITs- These REITs own large real estate properties like shopping malls, business centres, hotels, residential townships and make money by giving properties either on rent or lease agreements. The rental income earned is distributed as dividends to the unitholders Mortgage REITs- These REITs are not owners but provide finance to real estate projects of developers, builders, owners, etc. and earn income in the form of EMI and the Net Interest Margin is distributed as profits among the unitholders Hybrid REITs- These are companies which have both Equity and Mortgage REITs What are the advantages to investors investing REIT? REIT investing is the simplest and least capital intensive way of investing in real estate making it affording for an average investor to invest in them REIT, even though, are securities but represent real-estate, that is a separate asset class, thus diversifying your portfolio which has a low correlation to stocks As most of the investments in REITs are in steady income-generating properties by way of rentals, they are a reliable source of income for investors looking for a steady income. Moreover, they provide the opportunity of capital appreciation over the long-term as the value of the property goes up Strict regulations and norms of SEBI ensure transparency in operations and decrease the chances of fraud What are the risks of investing in REIT? Real estate is a great asset class for long-term investment purpose, and REIT provides a great alternative for retail investors to invest in real estate directly, as in investor you should be aware of certain REIT risks associated with your investment- The minimum investment amount of REIT is Rs 2 lakh, which is small when compared to directly investing in real estate but still a sizeable chunk of investible surplus for many investors Mortgage REITs are debts used to finance debts and subject to interest rate risk and default risk of the debtors REITs are required to pay 90% of their income as dividends, thus leaving very little capital for the trust to acquire newer properties REITs invest in high investment assets and hence trading in and out of REITs involves high transaction costs CONCLUSION The regulatory framework for REIT in India is very stringent, and SEBI guidelines and norms for REITs ensure that the interest of investors is safeguarded at all times when it comes to REIT investments. If you are looking out for exposure in quality real estate, then REITs may be the perfect investment option for you. Reach out to our experts at IndiaNivesh, who can guide you with the ins and outs of REIT investment in India best suited for you. Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
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