Internal Rate of Return (IRR)
The annualised rate of return a project is expected to generate - formally, the discount rate at which its Net Present Value equals zero.
Key takeaways
- IRR is calculated using the same maths as NPV, except you set NPV to zero and solve for the rate.
- It is the rate of discount that makes the present value of the project's cash inflows equal to the initial outlay.
- IRR is ideal for ranking and comparing capital projects on a like-for-like annual basis.
- Companies normally require IRR to exceed their cost of capital (WACC) for a project to be considered.
In plain English
Think of IRR as the annual growth rate the project is expected to deliver on the money you put in. If a savings account paid that interest rate every year, you'd end up with the same money in the end.
It's particularly useful for comparing projects of different sizes and shapes, because every project - a new factory, a solar array, a real-estate deal - gets reduced to a single annualised percentage.
The decision rule
Any project with an IRR greater than the cost of capital should, in theory, be profitable. In practice firms also set a Required Rate of Return (RRR) - a hurdle rate that sits above the cost of capital - and prioritise the projects with the biggest gap between IRR and the hurdle.
Limitations worth knowing
IRR assumes a single discount rate over the project's life, which is rarely true for long-horizon investments.
When cash flows switch sign more than once (negative, positive, negative…), the formula can produce multiple valid IRRs.
For these reasons IRR is almost always read alongside NPV, not on its own.