What it means
Simple return measures ignore time. A project that returns $150 on $100 over one year is far better than one that returns the same $150 over ten years, yet both show a 50% return on investment.
IRR corrects that by asking what compound annual rate would turn the outlay into the inflows on the dates they actually occur. It is, in effect, the interest rate the investment is paying you.
The IRR is found by trial and error or by a spreadsheet function, because the equation has no closed-form solution for more than two cash flows. The decision rule is then straightforward: accept projects whose IRR exceeds the hurdle rate (usually the weighted average cost of capital, adjusted for the project's risk), reject those that do not.
Private equity funds, property investors and venture capitalists quote IRR as their standard measure of performance because it captures both how much they made and how quickly. IRR has known weaknesses.
It assumes that interim cash flows are reinvested at the IRR itself, which overstates the return of projects with high IRRs; the modified IRR corrects this by assuming reinvestment at the cost of capital. It can give multiple answers, or none, when cash flows change sign more than once, for example a project with a large decommissioning cost at the end.
It says nothing about scale: a 40% IRR on $10,000 creates less value than a 15% IRR on $10 million. And it can rank mutually exclusive projects differently from NPV, in which case NPV should decide.
For those reasons finance theory treats NPV as the primary criterion and IRR as a useful, intuitive companion. In practice, IRR's intuitive appeal keeps it central.
Boards understand "this project earns 18% a year" more readily than "this project has an NPV of $2.3 million at a 9% discount rate", and the two statements are consistent.
In practice
Real-world examples.
Example
A private equity fund buys a company for $50 million and sells it four years later for $120 million with no interim distributions; the IRR is (120/50) to the power (1/4) minus 1 = 24.5% a year.
Example
A property developer compares two schemes with the same cash requirement and chooses the one with an IRR of 22% over one at 17%.
Example
A utility rejects a solar project with an IRR of 6.5% because its regulated cost of capital is 7%, even though the project would be profitable in accounting terms.
Think of it
“IRR is like the interest rate a bond would need to pay to be worth exactly what you paid for it. It's the investment's effective yield.
Formula
Calculation
IRR is the rate r that satisfies: 0 = Sum over all periods t of [ Cash Flow in period t / (1 + r) to the power t ]
Equivalently: the rate at which NPV = 0
Worked example. A company invests $200,000 in equipment expected to generate net cash inflows of $70,000 at the end of each of the next four years.
Try 12%: present value of inflows = $70,000 x 3.037 = $212,600; NPV = $212,600 minus $200,000 = +$12,600. IRR is higher than 12%.
Try 16%: present value = $70,000 x 2.798 = $195,900; NPV = minus $4,100. IRR is lower than 16%.
Try 15%: present value = $70,000 x 2.855 = $199,850; NPV = minus $150. Very close.
Try 14.9%: present value = $70,000 x 2.861 = $200,270; NPV = +$270.
IRR is approximately 14.96%. If the company's cost of capital is 10%, the project clears the hurdle by about five points. If the cost of capital were 16%, the project would be rejected.
Ranking example. Project A: invest $100,000, receive $130,000 in one year. IRR = 30%, NPV at 10% = $18,180. Project B: invest $1,000,000, receive $1,200,000 in one year. IRR = 20%, NPV at 10% = $90,910. If the company can do only one, IRR favours A and NPV favours B. B creates five times more value. NPV should decide, unless the capital constraint is real and the company can find other high-IRR uses for the money A leaves free.Case study
Seen in the real world.
A manufacturing group's capital committee approved projects by ranking them on IRR and funding from the top until the budget ran out. Over three years it approved dozens of small automation projects with IRRs of 30% to 50% and repeatedly deferred a $40 million plant modernisation with an IRR of 16%, above the group's 11% cost of capital but never high enough to reach the top of the list. The finance director eventually showed the board that the deferred plant project had an NPV of $18 million, more than all the small projects approved in the same period combined, and that each year of delay was costing the group roughly $2 million of value.
The committee changed its rule: projects are screened on IRR against the hurdle, then ranked on NPV, and a project whose NPV exceeds a threshold is considered on its own merits rather than in competition for the annual budget. The plant modernisation was approved the following quarter.
Watch out
Common mistakes.
- Using IRR to choose between projects of different sizes. It measures rate, not amount; NPV measures value.
- Trusting a single IRR when cash flows change sign more than once. There may be several solutions or none; use NPV or modified IRR.
- Comparing IRRs computed over different time horizons or with different treatment of interim cash flows, especially in fund performance claims.
Questions
People also ask.
What is a good IRR?
One that exceeds the cost of capital for the risk involved by a comfortable margin. Corporate projects often require 10% to 15%; venture investments target 25% or more to compensate for failures.
How is IRR different from ROI?
ROI is a simple percentage gain that ignores timing. IRR is the annualised rate that accounts for when each cash flow occurs.
How is IRR different from NPV?
NPV gives the value created in currency at a chosen discount rate. IRR gives the rate at which value created is zero. They usually agree on accept or reject decisions but can disagree on rankings.
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