In the world of investments, there are numbers and mathematical calculations involved that help to assess any given investment. A “probability” determines how profitable the investment will be. To assess the profitability of an investment you need certain metrics. That is where XIRR vs IRR come in, but what exactly are they? Let’s explore.
IRR or the Internal Rate of Return measures the average return on an investment. The IRR and the return on investment are directly proportional.
Higher IRR ∝ Better/Profitable Investment
This financial metric measures the profitability of a single investment while comparing it to other investments. The best case for IRR is to compare the profitability of investments with regular cash flows.
In the XIRR vs IRR debate you can use IRR to compare investments with different cash flow patterns. To do so, you or your financial advisor need the NPV or the Net Present Value.
Net Present Value (NPV)
Net Present Value (NPV) is a financial metric that calculates the present value of future cash flows, helping assess the profitability of an investment.
In the XIRR vs IRR debate, the Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment becomes zero, indicating the project’s potential profitability.
NPV= Cash flow / [(1+required return or discount rate)^)number of time periods)]- initial investment
So, how does it relate to the IRR?
Net Present Value (NPV) is a financial metric that calculates the present value of future cash flows, assessing an investment’s profitability. Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment becomes zero, indicating the project’s potential profitability.
Both metrics aid in investment decision-making. To find out how IRR helps in calculating investments, you must also know how to find the IRR when it comes to assessing your investments’ potential profitability in the XIRR vs IRR method.
How to Calculate IRR
|0 = NPV = t∑t=1 Ct/(1+IR R)t − C0
- Ct = Net Cash Inflow During Period t
- C0 = Initial Investment Cost
- IRR = Internal Rate of Return
- t = Number of Time Periods
The IRR formula makes the value of future cash flows equal to zero. Therefore, when you calculate the NPV of a project or an investment using the latter method out of the XIRR vs IRR as the discount rate and subtract the initial investment, the NPV should be zero.
Advantages of IRR
Finds the Time Value of Money
You can measure the IRR by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years remains considered and, therefore, each cash flow has equal weight by using the time value of money.
Easy to Use and Understand
Out of the XIRR vs IRR, the IRR is easy to calculate and provides you with a simple mean against which you can measure the worth of multiple investments. It provides every investor with a quick snapshot of what renewable energy projects will have the greatest cash flow.
You Don’t Need a Hurdle Rate
The hurdle rate or cost of capital is the required rate of return at which investors agree to fund a project. The IRR method does not need the hurdle rate. Once your portfolio manager calculates the IRR, you can select projects where the IRR exceeds the estimated cost of capital.
Like the IRR calculates the internal cash flow rate out of the XIRR vs IRR, you need another metric to assess the cash flows and discount rates and the corresponding dates. That is where XIRR comes in.
XIRR or Extended Internal Rate of Return is another financial metric that calculates the rate of return of your investment based on cash flow. The XIRR refers to the returns that you earn over some time and the amount of all the cash inflows and outflows including capital gains, dividends, etc.
How to Calculate XIRR
Calculating the XIRR out of the XIRR vs IRR is easy as you can do so with the XIRR calculator in Microsoft Excel. All you have to do is input the right command and values so that the system can give you accurate calculations. Calculate the XIRR of your investments in solar energy projects by inhibiting this formula:
XIRR (value, dates, guess)
- Values= represents the series of cash flows
- Dates= Series of dates that correspond to the first and future investment dates
- Guess= The initial guess or value of what the IRR would be
With this XIRR function, you have more than an ROI percentage and you have taken into consideration specific date-scheduled cash flows.
You get the calculations for an annualised return of an investment with irregular cash flows. In the XIRR vs IRR debate, each has its rate of return. Since there are variations, some experts consider that a benchmark of rate to be “good. ”
What Is a Good XIRR?
A good XIRR value is subjective. It depends on the investment and the financial goals of the investor (you). However, if you have to quantify it, then an XIRR of 11-12% is in the case of equity and 7-8% is in the case of debt mutual funds. Regardless of this, there is no doubt that XIRR is highly beneficial for your investment journey in solar projects. So. let’ see its benefits.
Advantages of XIRR
The former out of the XIRR vs IRR allows you to plug in all the data that corresponds to the date. This helps to get a clearer picture of how your investment is performing. It also tells you which investment is performing better.
XIRR helps you to calculate your rate of return accurately, especially when you have different investments. It gives an accurate estimation regarding all the investments.
Accounts for Cash Flow Timings
XIRR considers the cash flow timings when it comes to buying and selling a solar energy project. It would not only look at the purchased and sale prices but also associated cash flows to make the correct estimation.
Comparing Investment Opportunities with Different Timelines
XIRR can compare investment opportunities with different timelines. For example, if two solar energy projects are there for purchase or investment, but will take longer to return the investment, XIRR can tell you which one would provide the better return. This flexibility makes XIRR an invaluable tool for real estate investors.
While both have the end goal of calculating the ROI to let you know which investments are best for your portfolio, one does tower over another. So, “XIRR vs IRR: Which one is better for me?”
Difference Between XIRR and IRR
The key difference between the extended internal rate of return and internal rate of return is how each handles cash flow. IRR does not consider when the actual cash flow occurs, so it rolls the cash flow into annual periods.
On the other hand, the XIRR formula considers the dates when the cash flow usually takes place. Due to this, out of the XIRR vs IRR debate, XIRR is a more accurate way to evaluate your investment.
If you want an evaluation of your investment that is more precise you can choose the XIRR method. But if you want to calculate the investment over a period of time, then go for IRR.
FAQs: Crunching Numbers in Solar: XIRR vs IRR Unveiled for Maximum Returns
What is the key difference between XIRR and IRR?
XIRR incorporates irregular cash flows and variable time intervals, enhancing IRR by accommodating more complex financial scenarios.
In what scenarios is XIRR more suitable than IRR?
XIRR is better when dealing with investments with non-uniform cash flows or when cash flows occur at irregular time intervals.
Should I use XIRR for solar energy investment projects?
Choose XIRR for solar energy investment due to varying cash flows over time, providing a more accurate evaluation in dynamic scenarios.
Are there any common misconceptions about XIRR and IRR that investors should be aware of?
A common misconception is assuming IRR is sufficient for all scenarios. XIRR is essential for projects with irregular cash flows or non-annual compounding periods.
How to calculate the rate of returns of your investments?
Your portfolio manager will calculate your rate of returns using the IRR or XIRR methods with the Excel functions to help decide the best investments for your financial gains.
Regardless of which method you choose, (taking into consideration your financial goals) XIRR vs IRR, your investment purpose is the same. The portfolio managers will give you a rough estimation of your returns on a solar project. This will help you to assess not only your profit but also how that will reflect on your investment portfolio. Grow your portfolio with the guidance of experts in solar energy investments from Sustvest.
Founder of Sustvest
Hardik completed his B.Tech from BITS Pilani. Keeping the current global scenario, the growth of renewable energy in mind, and people looking for investment opportunities in mind he founded SustVest ( formerly, Solar Grid X ) in 2018. This venture led him to achieve the ‘Emerging Fintech Talent of the Year in MENA region ‘ in October 2019.