What it means
IRR answers a simple question: if this project were a savings account, what interest rate would it be paying? Because it comes out as a single percentage, it can be compared directly against the cost of borrowing or against a hurdle rate the board has set.
The calculation works by trial and error rather than a neat formula. A spreadsheet tests different discount rates until it finds the one that makes the present value of the inflows equal to the outflow, and that rate is the IRR.
In practice IRR is used alongside net present value rather than instead of it. Net present value tells you how much value a project adds in dollars, while IRR tells you the rate of return, and a small project with a spectacular IRR can add far less value than a large one with a modest IRR.
The metric has real weaknesses that matter in decision making. It assumes interim cash flows are reinvested at the IRR itself, which is often unrealistic, and projects with cash flows that switch between positive and negative more than once can produce multiple mathematically valid answers.
The common variant is the modified internal rate of return, which fixes the reinvestment assumption by discounting outflows at the cost of capital and compounding inflows at a realistic reinvestment rate. Private equity firms also report a money multiple alongside IRR, because a short holding period can flatter the percentage enormously.
In practice
Real-world examples.
Example
A logistics firm compares replacing its fleet, with an IRR of 14%, against automating a warehouse, with an IRR of 19%. Both beat its 9% cost of capital, so the finance director ranks them by net present value as well, since the fleet project is four times larger in dollar terms.
Example
A property developer buys a site for $2,000,000 and sells the completed units three years later for a net $3,200,000 with no interim cash flows. The IRR works out at roughly 17% a year, which is the figure the investors are actually paid on.
Example
A private equity fund reports a 32% IRR on an exit after fourteen months, but the money multiple is only 1.35 times. The limited partners note that the impressive percentage comes mainly from the short holding period rather than from exceptional value creation.
Think of it
“IRR is the effective annual return on investment-considering when money moves.
Formula
Calculation
IRR is the discount rate r at which: initial investment = sum of each year's cash flow divided by (1 + r) raised to the power of that year
A machine costs $300,000 and is expected to produce net cash of $110,000 in year one, $121,000 in year two and $133,100 in year three, after which it is scrapped for nothing.
Test a discount rate of 10%. Year one gives $110,000 / 1.10 = $100,000, year two gives $121,000 / 1.21 = $100,000, and year three gives $133,100 / 1.331 = $100,000.
The three discounted inflows total $100,000 + $100,000 + $100,000 = $300,000, which is exactly the initial cost, so the net present value at 10% is zero and the IRR is precisely 10%. If the company's cost of capital is 8%, the project clears the hurdle; if it is 12%, the project destroys value despite generating $364,100 of total cash on a $300,000 outlay.Case study
Seen in the real world.
The following is an illustrative and fictional example. Torrent Bottling, an invented drinks packager, had a capital committee that approved projects purely on IRR, with a hurdle of 15%. Over three years it approved eleven small automation projects with IRRs between 22% and 40% and rejected a new production line showing 16%.
The small projects were genuinely good but tiny, adding perhaps $80,000 of net present value each. The rejected line would have added about $4,000,000 of net present value, and the invented committee had turned it down simply because its percentage return was less exciting.
When a new finance director required both IRR and net present value on every paper, and a capital ranking by value added per dollar of scarce capital, the production line was approved the following year. In this fictional account the lesson was that IRR is a good screening tool and a poor ranking tool.
Watch out
Common mistakes.
- Ranking projects by IRR alone, which systematically favours small, quick projects over larger ones that create far more value.
- Ignoring the reinvestment assumption built into IRR, which implicitly assumes every interim cash flow earns the same high rate.
- Calculating IRR on cash flows that change sign more than once without noticing that several different rates can satisfy the equation.
Questions
People also ask.
What is a good IRR?
There is no universal figure; it only means anything relative to your cost of capital and the risk of the project, so a 12% IRR is strong for infrastructure and weak for early stage venture investing.
How is IRR different from return on investment?
Return on investment is a simple total gain over cost with no reference to timing, while IRR is an annualised rate that accounts for when each dollar arrives.
Why does my spreadsheet return an error for IRR?
Usually because the cash flows never change sign, so no rate can make the net present value zero, or because the starting guess is too far from the answer.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%