What does Internal Rate of Return (IRR) & Extended IRR actually represent in finance?
In: Economics
So imagine you want to buy a garden hose.
There are many varieties of hoses, some with a half inch wide hole and 10 ft length. Some with quarter of an inch he and 20 ft length.
Given the standardized average pressure of water in your garden tap, if I give you a formula which calculates the farthest a garden hose can water your lawn while starting out from your doorstep – That would give you a good idea of which hose to buy.
That’s what IRR translates to in Real life.
XIRR works like this —
Imagine you finalized which hose to buy. Now your local municipality tells you that after one year, we’re gonna halve the pressure of water to your home. To compensate, you will make some adjustments, maybe cut the length of your pipes to ensure the pressure stays constant.
Or maybe 2 years after that, they say hey, we’re gonna quadruple the pressure of water. You may then want to invest in a stop cock or an extension hose to ensure you stay ahead of the curve in your annual lawn watering competition.
Thats what the IRR and XIRR would calculate – it being the average square area of lawn you would be able to water while standing on your doorstep in different scenarios and comparing products on that.
IRR is the interest rate (technically, rate of return) at which your total costs over time matches your total benefits over time.
For instance, if you put in $1,000 today and expect to withdraw $10,000 in 15 years, the IRR would be the interest rate that balances a cost of $1,000 today with the benefit of $10,000 15 years in the future. Obviously, when you do this in a forward-looking way it has to be an estimate.
IRR requires an fixed recurring period, such as monthly or annually. XIRR just lets you use ***any*** dates, and does not require a fixed period.
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