IRR vs. XIRR: Meaning, Formula and Difference

Investments that involve multiple inflows and outflows over time require nuanced metrics that reflect both the timing and volume of these transactions. The internal rate of return (IRR) and the extended internal rate of return (XIRR) are two such measures used to assess returns. This article explains what IRR and XIRR are, how they are calculated, and the differences between them.

Table of contents

• What is the internal rate of return?
• IRR formula and how to use it
• What is XIRR?
• XIRR formula and its application
• IRR vs. XIRR in Excel
• Practical applications of IRR and XIRR
• Why XIRR offers a more accurate representation
• IRR vs. XIRR: Pitfalls and best practices
• Key points: IRR vs. XIRR
• When to choose IRR or XIRR

What is the internal rate of return?

IRR measures the annualized rate of return on an investment where there are multiple cash flows — meaning money going in and out at different times (like multiple investments, follow-ons, or exits). It doesn’t assume a single start and end value; instead, it finds the rate that makes the present value of all inflows = outflows.

In more formal terms, the internal rate of return (IRR) is the discount rate at which the net present value (NPV) of all future cash inflows and outflows from an investment equals zero, after accounting for the timing of each cash flow.

IRR assumes that all cash flows occur at regular intervals, such as annually or quarterly. IRR helps compare potential returns from projects or investments that generate predictable, evenly spaced cash flows.

Read Also: Mutual Fund Returns: CAGR, XIRR & Absolute Returns Explained

IRR formula and how to use it

The IRR is mathematically defined as:

IRR is commonly used when analysing projects with periodic or fixed-term cash flows, such as business expansion plans or structured investments. However, if the timing of cash flows is irregular, IRR may not provide a realistic measure since it assumes equal time gaps between inflows and outflows.

What is XIRR?

The extended internal rate of return (XIRR) is a modified version of IRR that accounts for cash flows that happen irregularly. It is more suitable for investments where inflows and outflows happen at different times. For example, in Systematic Investment Plans (SIPs), real estate transactions, or projects with irregular receipts or payments.

XIRR formula and its application

In Excel, the XIRR function is expressed as: =XIRR(values, dates, [guess]),

Where:

• values: Array of cash flows (negative for investments, positive for returns)
• dates: Corresponding dates of each cash flow

Conceptually, the XIRR formula is represented as:

Where:

Since XIRR discounts each cash flow based on the exact number of days between transactions, it provides a relatively precise annualised rate of return for investments with irregular timing.

IRR vs. XIRR in Excel

In Microsoft Excel:

• The =IRR() function assumes all cash flows occur at equal intervals and requires only a list of values.
• The =XIRR() function shows both values and actual dates, varying for irregular intervals between cash flows.

For instance, if you invest Rs. 1,00,000 on April 10, 2020, and receive Rs. 40,000 on April 10, 2021, and Rs. 70,000 on November 5, 2021, the IRR function would consider these returns to be uniformly distributed, but XIRR would compute returns based on the true time gap and provide a realistic result.

Example for illustrative purposes only.

Hence, when financial analysis is done using Excel, the choice between IRR and XIRR depends on whether your cash flow dates are uniform or irregular.

Practical applications of IRR and XIRR

Both IRR and XIRR are used in:

• Project evaluation: Businesses assess expansion projects with predictable annual returns (IRR is suitable).
• Real estate investments: Where purchase and sale proceeds occur on irregular dates (XIRR suitable).
• Mutual funds and SIPs: XIRR is considered more suitable for investments made and redeemed on different dates.
• Portfolio performance measurement: XIRR provides a money-weighted rate of return reflects the impact of cash-flow timing and size on your portfolio performance — suitable for SIPs and real-world investing.

Why XIRR offers a more accurate representation

XIRR incorporates actual cash flow dates, capturing the time value of money more precisely than IRR. Yearly returns can be greatly impacted by small changes, such as receiving payment a few months early or late. IRR can either overestimate or underestimate a true return when applied to unforeseen cash flows. For investments such as SIPs or projects with irregular cash flow schedules, XIRR may offer a more realistic measure of performance.

IRR vs. XIRR: Pitfalls and best practices

Common pitfalls:

• Using IRR for irregular cash flows may give misleading results.
• Both IRR and XIRR assume reinvestment at the computed rate, which may not occur in practice. This assumption can lead to overestimation of returns in high-interest environments or underestimation in declining-rate scenarios, potentially affecting investment decisions.
• Multiple IRRs can occur if cash flows change direction (from inflow to outflow) more than once.
• Comparing IRR values across different projects without considering time period or risk can be inaccurate.

Best practices

• Examine the pattern and timing of all cash flows before choosing a metric.
• Use XIRR when cash flows are irregular and IRR when they occur at fixed intervals.
• Combine NPV with IRR or XIRR analysis for a comprehensive financial assessment.
• Maintain accurate records of cash flow dates for transparency.
• Clearly state assumptions, such as reinvestment rates and duration.

Key points: IRR vs. XIRR

• Map all inflows and outflows with their actual dates before analysis.
• IRR is more suitable for evenly spaced cash flows.
• XIRR is suitable for irregular or multiple transactions.
• In Excel, use = IRR(values) for regular intervals and = XIRR(values, dates) for irregular ones.
• A higher IRR or XIRR does not necessarily imply a superior investment; risk, liquidity, and time horizon are also important.

Read Also: Annualised Return - Meaning, Formula and Calculation

When to choose IRR or XIRR

• Use IRR for projects or investments with regular cash flows, such as annual business payments.
• Use XIRR for investments with differing dates or timing, such as SIPs, real estate, or staggered transactions.
• If timing is uncertain, XIRR may provide a more realistic picture of performance.
• In most real-world scenarios, XIRR offers a more representative measure than IRR, which is better suited for theoretical or classroom use.
• If possible, disclose both metrics and explain the differences between IRR and XIRR to guarantee analytical clarity.

FAQs

What is the difference between IRR and XIRR?

The key difference lies in how they handle time. IRR assumes equal intervals between cash flows, while XIRR uses actual dates, making it more suitable for irregular investments.

When should I use XIRR instead of IRR?

Use XIRR when inflows and outflows occur on different dates, such as in SIPs or real estate transactions.

Can XIRR handle negative cash flows?

Yes. XIRR works with both positive cash flows (inflows) and negative (outflows) cash flows, provided there is at least one of each.

How do I calculate XIRR in Excel?

List all cash flows in one column and corresponding dates in another. Then use the formula: =XIRR(values_range, dates_range, [guess]) where values_range are the cash flows and dates_range are the dates of each cash flow. The guess parameter is optional and provides an initial estimate for the iteration.

Past performance may or may not be sustained in future

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