How to calculate returns on investment – using IRR

How to calculate returns on investment – using IRR

If you’re looking to raise funds for your startup, the first question an investor will ask is what’s the return?

And if you think that’s easy, it’s the annual profit divided by the investment, you’ll be wrong, e.g. annual profits of £75,000 with an investment required of £250,000 gives a return of 30%. It’s a common mistake and easily made.

The mistake is that the investment or project has a finite life since every investor will look to sell out at some stage.

The correct way to calculate a return over a fixed period of time is to calculate a rate of return on the cash flows over the period. This is easily done by using spreadsheets and the internal rate of return function (IRR) – excel makes it very easy. It’s called the internal rate since external factors such as interest rate deductions or inflation are not taken into account in the cashflows – it should only take into account the cashflows generated by the project itself.

For e.g. in the instance above, the outflow at the start would be £250,000 (the investment) followed by say £50,000 cash inflows (the net cash returns) in year 1 followed by £75,000 in years 2 to 5, using the IRR method would give an annual return of 12%. If this rate is higher than what the investor usually wants, then they would invest into the project.

This is the correct method for any business to use when also evaluating new projects or products. If the IRR returns a rate higher than the cost of capital for the business  then it’s worth doing. For e.g. if you’re borrowing funds and it costs say 8% interest on a loan, then the above example would be a viable project.

IRR is a favourite tool used by FDs, CFOs and investment analysts because it gives an objective rate when evaluating lots of potential investments or projects. Of course, in real life, things are more complicated, with risk being one of the key factors to be taken into account. It’s risk that makes investors into any startup look for high returns and 25%-30% IRR is a common range you will hear investors ask for.

In the above example, to reach a return of 25%, would need the cash inflows to increase from £75k to £110k a year from year 2 to 5 – that’s a 46% increase in profits!

Knowing how to calculate IRR and present it in the right way would give potential investors comfort that at least you know what they are looking for and not every investor would look for the highest return if all the other factors such as risk and industry sector appeal to them.

Leave a Reply

Your email address will not be published. Required fields are marked *