What Is Internal Rate of Return (IRR)

Do you feel lost trying to decide what to invest in? What if you had a tool to help you identify the best potential path forward?

That’s how you can look at the internal rate of return (IRR): as a financial compass to guide you through the tangled thicket of possible investment opportunities. The IRR is an estimated rate of return that can help you decide whether a particular investment will likely be good.

Understanding Internal Rate of Return

The internal rate of return (IRR) is a financial metric used by companies and investors to estimate the return expected over the life of an investment.

The IRR is the discount rate that brings regular cash flows back to a net present value (NPV) of zero, meaning it calculates the rate of return at which an investment or project breaks even.

In practical terms, you don’t want an investment that provides no return on investment. Since the IRR has a corresponding relationship with the rate of return of a project or investment, it’s a useful tool for estimating potential profitability.

The internal rate of return (IRR) can be used to examine a project or investment's past or expected future performance. A high IRR means an investment is performing well or is expected to perform well. 

The internal rate of return allows you to compare investments or capital expenditures based on the amount of your initial investment and expected cash flow over a regular period.

Company leaders can compare the rate of return to their hurdle rate or cost of capital to decide whether to pursue a project. At the same time, investors can determine the highest expected rate of return to select from among several investments.

How to Calculate Internal Rate of Return

To calculate the internal rate of return, you’ll need to know your expected cash flows for a given period. You’ll set the net present value to zero (0), which means the amount of your initial investment for the starting period is equal to the present value of the investment’s future cash flows, which is zero.

You can calculate an IRR in three ways: using the IRR function in Excel, using a financial calculator or by hand, guessing the discount rate at which the net present value will equal zero.

Practical Example

Say you had $10,000 to invest. You find a suitable investment and estimate that your annual cash flows over the next three years will be $2,500, $3,500 and $5,500, respectively. Here’s how you’d calculate the IRR for the investment:

In an Excel spreadsheet, enter your initial investment in a cell as a negative number (-10,000). Then, enter an annual cash flow in the three cells below (2,500, 3,500 and 5,500).

Next, insert the IRR formula in a separate cell. To find the formula, go to the function line at the top of the spreadsheet and choose “Formulas.” The function (fx) ribbon will appear. When you hover over the icons, “Financial” will appear.

From the drop-down menu, scroll down and select “IRR.” Follow the on-screen instructions, and voilà — your investment will have an IRR of 6%.

If that’s higher than what your money is earning now or your other investment options, you might decide it’s a good investment.

What Is Internal Rate of Return Used For?

Businesses use the internal rate of return to analyze competing projects or investments and decide which ones to fund. As an investor, you can use it to weigh investment choices.

While the IRR doesn’t consider outside risks, one of its major advantages is that it captures the time value of money, making calculations more accurate. 

As mentioned earlier, the discount rate reduces the net present value (NPV) to zero.

The NPV is another valuable business calculation that measures the difference between the present value of cash inflows and cash outflows over a specific period. It also captures the time value of money, reflecting factors like inflation, volatility, uncertainty and lost opportunity costs.

Importance of Internal Rate of Return

The internal rate of return is highly valuable when comparing projects or investments. It’s calculated from the project or investment’s initial cash investment and cash flows, allowing you to reliably rank options based on returns, all else being equal.

While it’s a valuable business tool, the internal rate of return has its limitations, which include:

• Cash flow timing
• Reinvestment assumptions
• Project size
• Project duration
• Unconventional cash flows

Because of these limitations, business leaders evaluating a single project often turn to net present value for analysis.

Unlike the internal rate of return, NPV can work with fluctuating cash flows and present diverse discount rates. It can also deliver an exact figure for the present value of expected future cash flows because it factors in the time value of money and risks. However, you can always turn to the IRR when you can’t find an NPV.

Disadvantages of Internal Rate of Return

One of the main disadvantages of the internal rate of return is that it assumes the reinvestment of positive cash flow at the IRR. It also doesn’t consider a project’s cost of capital or duration. Additionally, if you have cash flows alternating from positive to negative, you can get multiple values for the internal rate of return.

These disadvantages can lead to poor decision-making. Assuming the same rate of reinvestment rather than factoring in the cost of capital could provide an inaccurate picture of a project or investment’s profitability and cost.

Moreover, by not comparing the duration of various projects, a higher IRR on a short-term project could prompt you to choose it over a long-term project that might be more profitable.

Internal Rate of Return vs. Return on Investment (ROI)

Though they have similar features and functions, the internal rate of return and return on investment metrics differ slightly. The IRR gives you the annual growth rate, while ROI shows you the total return on your investment. Also, the IRR captures the time value of money, while ROI doesn’t.

As an investor, you may find both the internal rate of return and return on investment metrics useful.

Use Internal Rate of Return to Analyze Investments

The internal rate of return is a useful metric for analyzing and comparing the potential profitability of various projects and investments. Understanding its advantages and limitations can guide you in evaluating your investment options. It’s a good tool to have in your investment toolbox.

Frequently Asked Questions