What Is Internal Rate of Return (IRR)?
The Internal Rate of Return (IRR) is a core financial metric used in capital budgeting to estimate the profitability of potential investments. It is a discount rate that makes the Net Present Value (NPV) of all cash flows (both positive and negative) from a particular investment equal to zero. In simpler terms, the IRR is the annualized rate of return an investment is expected to generate. A IRR calculator is a critical tool for financial analysts and investors because the formula cannot be solved directly; it must be found through trial and error, a process that computers can perform almost instantly.
How to Interpret IRR
The primary rule for making a decision based on IRR is to compare it to a company's required rate of return or cost of capital. A simple way to think about it is:
- If IRR > Required Rate of Return: The investment is considered profitable and should be accepted, as it is projected to earn more than the cost of funding it.
- If IRR < Required Rate of Return: The investment is expected to return less than the cost of capital and should be rejected.
When comparing multiple mutually exclusive projects, the one with the highest IRR is generally considered the most desirable. However, it's crucial to use IRR in conjunction with other metrics, as it has some important limitations.
The Formula Behind IRR
The IRR is the rate 'r' that solves the following equation, where the Net Present Value (NPV) is set to zero:
- CFt: The cash flow during period 't'. The initial investment is CF0 and is typically a negative number.
- r (IRR): The internal rate of return.
- t: The time period in which the cash flow occurs.
This formula calculates the present value of each cash flow and sums them up. The IRR is the specific discount rate that makes this sum exactly zero. For investments with just a start and end value, the calculation is simpler and is known as the Compound Annual Growth Rate (CAGR), which you can find with our Average Return Calculator.
A key limitation of the IRR model is its assumption that all positive cash flows are reinvested at the same IRR rate. This may not be realistic, especially if the IRR is very high. For a deeper dive into the nuances of capital budgeting and IRR, financial education resources like Corporate Finance Institute (CFI) provide excellent explanations.