What it means
Imagine you pay $100,000 for a project and receive cash back over three years. The IRR answers the question: what steady annual interest rate would make those cash flows worth exactly $100,000 today?
Because it is expressed as a percentage, it is easy to compare with a company's hurdle rate, which is the minimum return the business requires. A project with an IRR above the hurdle rate adds value, and one below it destroys value.
IRR is closely related to net present value, or NPV, which is the value of future cash flows today minus the investment. IRR is simply the discount rate at which NPV equals zero.
It must be found by trial and error or with a spreadsheet function, because there is no simple formula for more than two cash flows. The measure has well-known weaknesses.
It assumes that cash released by the project can be reinvested at the IRR itself, which may be unrealistic for a very high return, and it can give several answers, or none, when cash flows switch between positive and negative more than once. For mutually exclusive projects, IRR can also mislead because a small project with a high percentage may add less total value than a larger one with a lower percentage.
Analysts therefore use IRR alongside NPV and sometimes the modified IRR, which uses a more realistic reinvestment rate. Private equity, real estate and corporate finance teams all rely on it.
It summarises a project's profitability in a way that executives and investors understand, provided its assumptions are made clear.
In practice
Real-world examples
Example 1
A retailer considers opening a new store that costs $500,000 and is expected to generate cash flows for ten years. The finance team calculates an IRR of 14%, compares it to the hurdle rate of 10%, and approves the project.
Example 2
A property investor compares two buildings with different purchase prices and rental incomes. She calculates the IRR of each over a seven-year holding period, including the sale price, and chooses the building with the higher return.
Example 3
A venture capital firm backs a start-up with $2,000,000 and expects to sell its stake in five years. The partners estimate the IRR under several exit scenarios to see what valuation they need to reach their target return.
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
NPV = -Initial investment + Cash flow in year 1 / (1 + IRR) + Cash flow in year 2 / (1 + IRR)^2 + ... = 0
A company invests $100,000 and receives $40,000 in year 1, $50,000 in year 2 and $29,700 in year 3. Test a rate of 10%. The present values are 40,000 / 1.10 = $36,363.64, 50,000 / 1.21 = $41,322.31 and 29,700 / 1.331 = $22,314.05, which add up to $100,000.00. NPV at 10% is therefore 100,000.00 - 100,000 = 0, so the IRR is 10%. At 8% the NPV is about +$3,481, and at 12% it is about -$3,286, confirming that the answer lies between them.Case study
Seen in the real world
Oakridge Packaging is an illustrative, fictional company that considered two machines. Machine A cost $200,000 and had an IRR of 22%, while Machine B cost $600,000 and had an IRR of 16%.
The operations manager favoured Machine A because of the higher percentage. The finance director pointed out that with a cost of capital of 10%, Machine B added a much larger NPV of $180,000 against $60,000 for Machine A, because it earned a good return on three times as much money.
The fictional board chose Machine B, since the aim was to create the most value and not the highest percentage. The illustrative lesson is that IRR is a useful ranking tool, but it should be checked against NPV when projects differ in size.
Watch out
Common mistakes
- Choosing the project with the highest IRR without considering the size of the investment and the NPV.
- Ignoring the assumption that cash flows can be reinvested at the IRR, which can overstate returns for very high rates.
- Using IRR on cash flows that change sign several times, which can produce multiple answers or none.
Questions
People also ask
What is a good IRR?
A good IRR is one that exceeds the project's cost of capital or hurdle rate by enough to compensate for the risk, and this varies widely by industry and risk.
What is the difference between IRR and ROI?
ROI compares total gain with the amount invested and ignores timing, while IRR accounts for when each cash flow arrives and gives an annual rate.
How do I calculate IRR in a spreadsheet?
List the cash flows in order, including the initial outflow as a negative number, and use the IRR function on that range of cells.
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