1. Nominal Interest Rates vs.

Real Interest Rates

Suppose we buy a 1 year bond for face value that pays 6% at the end of the year. We pay $100 at the beginning of the year and get $106 at the end of the year. Thus the bond pays an interest rate of 6%. This 6% is the nominal interest rate, as we have not accounted for inflation. Whenever people speak of the interest rate they're talking about the nominal interest rate, unless they state otherwise. Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost $100, or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%. The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher Equation:

Real Interest Rate = Nominal Interest Rate - Inflation

If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation and the inflation rate is negative, then the real interest rate will be larger. The effective rate of return is the rate of interest on an investment annually when compounding occurs more than once.
It is calculated through the following formula:

Effective Rate Of Return = (1 + i/ n) n-1 Here; i stands for the annual interest rate N stands for the number of compounding periods It can be said that the Effective Rate Of Return determines the effect of compounding for the annual interest rate. It can be better explained this way that if an investment pays 5 percent per year but without any compounding than the effective rate of return will be 5 percent. On the other hand, if an investment is compounded monthly then the effective rate of return will be greater than 5 percent. If we move on to the importance of the effective rate of return then it is said to be important for 2 reasons. First one is that it is accurate. It is much more than estimating returns only. It helps in determining all the details that might be needed for compounding. Secondly, it is being popularly used as it is based on simple calculations of interests.

The effective rate of return helps to determine the return that will be gained on each investment and it covers up a number of marketing instruments, loans and investments. It can be said that effective rate of return is useful in determining what amount of money will be gained or lost on an investment during a given course of time. The amount that can be lost or gained might be profit, net income, interest or loss. In this way, the financial analysts are able to calculate what amount of gain or loss they will be born over the amount of money that they have invested in a particular thing over a certain time period.

What is IRR and XIRR and how to Calculate it

by Manish Chauhan 85 comments

How do you calculate your returns when you every year you invest different amount and at the end you receive your Money back? Suppose your invest 5000, 10000, 6000, 4000 and 6500 in 5 yrs and Get 53,000 at the end of 5 yrs then what is your Return? Its 17.4%. The concept is called IRR. Read below to understand more: So Here we will learn two things IRR and XIRR

What is IRR and How to Calculate it?

IRR is Internal Rate of Return and it is used to calculate the returns given some amount at a fixed interval i.e. after every 3 months or after every 1 yr. The only thing which matters is that there should be equal distance between two installments. We will learn how to Calculate IRR in Excel Sheet. You would also love to read what is NPV ( Net Present Value) . How to calculate?

Enter your Investments (amount which you paid) in each row (you have to put - before each value) Enter the Amount you Received at the end (put + after that amount) Formula: =IRR(values)( place your values put the range of cells which contains values) see below:

[ad#big-banner] Use this Spreadsheet to calculate IRR for yourself Things to NOTE

The values need to be a set of Positive and Negative Values The last value is the amount you receive Any amount Invested will be Negative so if you invest Rs 10000, put -10000 Any amount you Receive will be Positive so if you get Rs 5000, put +5000 All the payment or receiving of money are equidistant, Like 1st of every month OR May 15th Every year All the payments are assumed to be yearly by default. If its some other time frame like monthly or quarterly use XIRR and put specific dates.

In the above example, the CAGR return was 17%. See this video post to understand how to calculate
CAGR .

What is XIRR and How to Calculate it?

IRR does not solve one problem and that is when the payments are at Irregular interval. In that case we use XIRR. So in a Spreadsheet we put the date and the value both. See the example below: How to Calculate

Put Date and Value for each row At the last row put the Date and amount you received Put the formula as: =XIRR(values, dates), values and dates are the cell ranges

Use this Spreadsheet to calculate XIRR for yourself In the above example the CAGR Return was 38.96% (I have multiplied the return by 100 the actual value will be .3896)

Real Life scenario when you can use it

Scenario 1 Suppose you Invest in a Mutual Funds per month on your own , you invest on 15th of every month in year 2006

June 15 you invested 5000 July 15 you invested 6000 Aug 15 you invested 3000 Sep 15 you receive 5000 (dividend) Oct 15 you invested 4000 Nov 15 you invested 12000 Dec 15 you Sell everything and Receive 35000

You can use IRR in this case and calculate your returns , the values you will be -5000 , -6000 , 3000 , +5000 , -4000 , +12000 , Calculate the IRR and put it as comments , lets see if you are correct or not ? [ad#text-banner] Scenario 2 You can also compare two business ideas using the XIRR , and decide which one is better then other . In any business concept you have to invest money and you get back some return , but these returns can be irregular and different amount every time , In that case you can use XIRR and compare the returns of both business and decide the one which has better XIRR Note : the formula can give answers in a but different ways on Excel , OpenOffice spreadsheet , google docs or Zoho Spread sheet . Use this Spreadsheet to calculate IRR and XIRR for yourself . The spreadsheet is shared , so please dont make any changes other than values and dates .

Definition of 'Compound Annual Growth Rate CAGR'

The year-over-year growth rate of an investment over a specified period of time. The compound annual growth rate is calculated by taking the nth root of the total percentage growth rate, where n is the number of years in the period being considered. This can be written as follows:

Investopedia explains 'Compound Annual Growth Rate - CAGR'

CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns. Don't worry if this concept is still fuzzy to you - CAGR is one of those terms best defined by example. Suppose you invested $10,000 in a portfolio on Jan 1, 2005. Let's say by Jan 1, 2006, your portfolio had grown to $13,000, then $14,000 by 2007, and finally ended up at $19,500 by 2008. Your CAGR would be the ratio of your ending value to beginning value ($19,500 / $10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then

subtracting 1 from the resulting number: 1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333). 1.2493 - 1 = 0.2493 Another way of writing 0.2493 is 24.93%. Thus, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon.