Internal Rate of Return (IRR)

Internal rate of return (IRR) is one of several well-known formulas used to evaluate prospective investments, especially ones that generate cash flows, like in real estate. While IRR still involves projections, it can help bring clarity to investors deciding how to best deploy capital.

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."

Unlike traditional return calculations, IRR takes into account cash flow — the money coming in and out — and the general idea that money today is worth more than money tomorrow. It's often used to determine where a company's funds are best directed, especially when comparing investment options. IRR could also help determine whether it is more profitable to establish a new operation or expand your existing one.

Here, we'll take a closer look at what IRR is and how it's used.

Defining IRR 

Discount rate and NPV 

IRR can be quite complex when you dig into the details, but a simple definition of IRR is that it's an expected return rate that accounts for time, not just the pure growth of money.

The more technical definition of IRR is that it is the discount rate that makes the net present value (NPV) of an investment zero. That means the initial capital outlay (how much is invested at the beginning) is equal to the present value of all future cash inflows (money brought in) as a result of the amount invested.

Another way of putting that is that the IRR shows the rate that the initial investment would need to earn in order for that initial amount to be worth the same amount as future returns when accounting for time.

Confused? Don't worry. The average investor probably isn't going to get into the weeds of a discount rate and NPV. In many ways, this is just a mathematical explanation.

Instead, you might focus more on the practical implications of an IRR, such as comparing the IRR of two different investments. While it's not always as simple as a higher IRR being better than a lower one, as other factors like risk matter, it can point you in the right direction.

IRR and the hurdle rate

IRR is most often used in conjunction with hurdle rate — or the minimum return an investment needs to bring in to be worthwhile. Many companies use their weighted average cost of capital (WACC) as their base hurdle rate. For example, if a company's WACC is 5% and an investment has an IRR of 10%, then it could be worth raising capital to get that higher return.

"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."

IRR and other comparisons

In addition to the hurdle rate, IRR is also often used to see which investment option makes the most sense on a comparative basis. For example, if an IRR is 3% and current Treasury rates are 4%, then it might not make sense to go ahead with the investment, because your money could be better served by simply putting it into the relative safety of Treasuries. That said, you'd need to calculate variables such as the risk of rates changing in the future.

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).

IRR vs. NPV

One important point to understand is that IRR and NPV are not exactly the same. The confusion is that IRR calculates returns based on an NPV equal to zero. But that doesn't mean that an investor assumes the NPV is actually zero, this is just how the mathematical formula works.

Instead, think of it this way: NPV tells you the dollar value of a potential investment based on how much future cash inflows are worth in today's dollars. An investment might earn money, but because of the time value of money, it might have a negative NPV.

In contrast, IRR provides a percentage-based projected return when taking into account the time value of money. This percentage can be particularly useful when comparing it to other metrics, like the cost of capital, to see if a project is worth investing in.

How to calculate IRR

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:

Alyssa Powell/Insider

Equalizing inflows and outflows

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 and weigh if that rate is worth pursuing.

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 (while still earning the $40,000 for the year leading up to the sale).

The IRR, in this case, would be 33.54%. Note that this differs from the average annual return of 25% because the IRR essentially rewards the fact that your initial investment is more than recouped after year 3, which then gives you an opportunity to reinvest that money elsewhere and earn more.

Ultimately, if the IRR is higher than your hurdle rate — as well as the IRR of another similar investment you're considering — it's probably a smart use of your funds.

Pros and cons of IRR

Some of the best ways to use IRR include

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.

However, IRR isn't the only factor that matters. An investment might have a higher IRR but have much higher risk, so you might not actually get those projected returns, thus it might not be the best investment choice.

Project evaluation

Companies can use IRR to evaluate potential projects, like investing in new equipment or a new product launch, 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

While IRR can be a useful metric, there are some pitfalls to watch out for, such as:

Misleading or confusing results

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 way the math works with the IRR formula means you can end up with more than one value, and there's no universally accurate answer.

Assumptions

Another problem with using the IRR to evaluate a project is that it assumes what future cash flows will look like, but that might not pan out in reality. For example, a real estate project might have projected cash flows that end up not coming to fruition due to a lack of tenants in future years.

Also, the IRR implies that cash inflows are reinvested at the same rate as the IRR. The math here can get a little tricky, but essentially, there's risk such as that in future years, the reinvestment rates will be lower than what's presently available or the investment choices will simply differ from the current ones.

The bottom line on IRR

IRR can help you evaluate the potential of a new investment or endeavor compared to the cost of capital, 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 about IRR