What it means
Every investment has a pattern of cash going out first and cash coming in later. The internal rate of return, or IRR, is the single discount rate that makes the present value of the incoming cash exactly equal to the money paid out at the start.
The rule compares that rate with a benchmark, usually the company's cost of capital or a higher hurdle rate set by management. A project returning 14% when the business needs 10% creates value, while a project returning 7% destroys it.
Managers like the rule because it produces a percentage that is easy to communicate. A board can grasp that a project yields 14% a year more quickly than it can interpret a net present value figure of $38,000.
There are well-known weaknesses. When cash flows change direction more than once, a project can have several IRRs, and when comparing projects of different sizes or lengths, the higher IRR does not always mean the better project.
Because of this, finance teams commonly use the IRR rule alongside net present value rather than instead of it. Net present value shows the dollar value created, and the IRR shows the margin of safety over the required return.
The nuance is the reinvestment assumption. IRR implicitly assumes that interim cash flows can be reinvested at the IRR itself, which is optimistic for very high-return projects, and a modified IRR is sometimes used to correct that.
In practice
Real-world examples.
Example
A logistics company is considering a $400,000 warehouse automation project with an IRR of 16%. Its cost of capital is 9%, and management sets a hurdle of 12% for projects of this risk. The project clears the hurdle, so it is approved.
Example
A retailer compares two new store sites. Site A has an IRR of 11% and Site B has 15%, with a hurdle of 12%. The rule rejects Site A and accepts Site B.
Example
A pharmaceutical startup evaluates a trial that costs money for several years before any revenue arrives. The cash flows change sign twice, so the IRR is unreliable, and the finance lead relies on net present value for the final decision.
Formula
Calculation
IRR is the rate r that solves: 0 = -Initial investment + Cash flow 1 / (1 + r) + Cash flow 2 / (1 + r)^2 + ...
Decision rule: accept if IRR > required return; reject if IRR < required return.
Suppose a project costs $100,000 and returns $55,000 at the end of year one and $60,500 at the end of year two. Try r = 10%: 55,000 / 1.10 = $50,000 and 60,500 / 1.21 = $50,000, which total $100,000, so the IRR is exactly 10%. If the required return is 8%, the IRR is higher, so accept; the net present value at 8% is about $2,795. If the required return is 12%, the IRR is lower, so reject; the net present value at 12% is about -$2,663.Case study
Seen in the real world.
This is an illustrative story about a fictional packaging company, Tidewater Packaging, deciding between a new bottling line and a smaller labelling upgrade. The bottling line needed $3,000,000 and showed an IRR of 13%, while the labelling upgrade needed $300,000 and showed an IRR of 22%. The hurdle rate was 12%.
Both projects passed the rule, but the bottling line created much more total value in dollar terms because it was ten times larger. The CFO pointed out that the highest IRR did not mean the highest value, and the board asked for the net present value of each.
Tidewater approved both projects, since capital was available. The illustrative message is that the IRR rule tells you whether a project clears the bar, but a size-aware measure should decide between projects when money is limited.
Watch out
Common mistakes.
- Choosing the project with the highest IRR when budgets are limited. A small project with a high rate may add less value than a large one with a lower rate.
- Using the rule when cash flows switch sign several times. The calculation can give multiple answers or none that make sense.
- Comparing IRR to the wrong benchmark. The hurdle should reflect the project's risk, not just the company's average cost of capital.
Questions
People also ask.
What is a hurdle rate?
It is the minimum return management will accept, usually set at or above the cost of capital to allow for risk.
How is the rule different from the net present value rule?
NPV states the value created in dollars, while the IRR rule states the percentage return and compares it with the hurdle.
Can IRR be calculated by hand?
It usually requires trial and error or a spreadsheet function, because the equation cannot be solved directly once there are more than two periods.
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