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- Internal Rate of Return (IRR) is a formula used to evaluate the returns of a potential investment.
- IRR calculates the projected annual growth rate of a specific investment over time.
- It's often used to compare similar investments, or in capital planning and budgeting.
Internal rate of return (IRR) is one of several well-known formulas used to evaluate prospective investments. It allows you to calculate an investment's potential gains over a certain period of time and determine whether it's a worthwhile venture.
As Daniel Garza, CFA, who manages a research team at registered investment advisor Corient explains, "IRR is often used to determine the feasibility of investment projects."
Are you looking to assess a particular investment's potential? If you know how to calculate IRR, this metric can prove quite helpful.
IRR is used to calculate the potential annual returns of an investment over time, while taking into account cash flow — the money coming in and out. It's often used to determine where a company's funds are best directed.
For example, you might use it to evaluate whether Investment A or Investment B is the better use of your capital. IRR could also help determine whether it is more profitable to establish a new operation or expand your existing one.
Defining IRR
Discount rate and NPV
IRR is the discount rate that makes the net present value (NPV) of an investment zero. In other words, the initial capital outlay (how much is invested at the beginning) is equal to the present value of the future cash flows (money brought in) as a result of the amount invested.
Another way of putting that is that the upfront cost of the initial investment is equal to the present value of its future cash flows, and since these two are equal, the net present value is zero.
IRR is most often used in conjunction with hurdle rate — or the minimum return an investment needs to bring in. Many companies use their weighted average cost of capital (WACC) as their base hurdle rate.
"Once the IRR is obtained, it's compared to the hurdle rate in order to determine if the project is viable," Garza says. "If the IRR is higher than the hurdle rate, then the project adds value."
Quick tip: IRR is best used when comparing investments with similar durations and in tandem with other analyses, such as payback period and net present value (NPV).
How is IRR calculated?
A complex calculation
The IRR formula is complex, so it's rarely calculated manually. In most cases, investors use an IRR calculator or an Excel spreadsheet, which has a built-in function to determine a project's IRR.
Nevertheless, the exact formula looks like this:
When calculating IRR, you're solving for an NPV of zero. You'll then need the number of years you plan to hold the investment (N), as well as your expected cash inflows and outflows for those periods (CF1, CF2, etc.). From there, you can determine a project's internal rate of return.
Here's an example: Say you're on the fence about purchasing a $100,000 piece of equipment. You project it will bring in $40,000 in annual profits each year, until year six, when it's likely to be out of date or no longer functioning. At that point, you'll sell the equipment for $10,000.
Year | Cash flow |
0 | -$100,000 |
1 | $40,000 |
2 | $40,000 |
3 | $40,000 |
4 | $40,000 |
5 | $40,000 |
6 | $10,000 |
The IRR, in this case, would be 29.7%. If that IRR is higher than your hurdle rate — or the IRR of another similar investment you're considering — it's probably a smart use of your funds.
Using IRR in investment decisions
Comparing investments
If you are looking at two potential investments, the one with the higher IRR is likely to be a more worthwhile venture, as the higher value for this metric implies a greater potential return. If you are evaluating multiple potential ventures, you can use IRR to rank and prioritize them using IRR to predict the returns they might generate.
Project evaluation
Companies can use IRR to evaluate potential projects by measuring their expected return. Before deciding whether to pursue a specific project, a company might calculate that project's IRR and make sure that figure is higher than the hurdle rate, which is the minimum return that a project must provide in order to be considered worthwhile.
Considerations when using IRR
Uneven cash flows
IRR certainly has its limitations. More specifically, the IRR can potentially be misleading when used to evaluate projects that have uneven cash flows. For example, if a project generates a positive cash flow in the first year, a negative one in the second, and then a positive cash flow in the third year, the resulting IRR can have more than one value.
Assumptions
Another problem with using the IRR to evaluate a project is that it assumes that any and all interest payments or dividends are reinvested in the project. However, the company making the investment may want to take these dividends and pay them to the shareholders instead of reinvesting them.
IRR can help you evaluate the potential of a new investment or endeavor, as well as compare it with other options you might be considering. Just make sure you incorporate other analyses and consider using a calculator or Excel's IRR function to ease the process. If you need help determining whether a new investment is a smart move or not, consider contacting a financial analyst or financial advisor. They can help you run the numbers and make the best choice.
FAQs
Unlike the regular return, the IRR accounts for the time value of money and also considers the compounding of cash flows.
Generally, a higher IRR is better, since it points to greater expected returns for a project. However, investors should keep in mind that IRR has its limitations, so they should use it along with other financial metrics, for example NPV, before making any decisions.
The answer to this question depends on many variables, including your desired rate of return, along with the type of investment and its unique risks.
A project's IRR can be negative if the outflows it generates have a greater monetary value than the inflows it creates.
If you want to calculate IRR using Excel, you can use the IRR function.
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