Internal Rate of Return: How to Calculate and Use IRR

Rate-of-return metrics calculate the rate of cash inflow that comes back to your business after an investment or cash outflow for a project—more specifically, the internal rate of return is the anticipated compound annual rate of return for a project or investment. It represents the rate at which an investment should break even from profits or interest accrual, or the interest rate that makes the net present value (NPV) zero. The calculation uses the project’s initial investment and cost of capital, plus estimates of future cash flows and outlay, to determine the potential interest rate.

When a simple rate-of-return calculation isn’t feasible because the anticipated net cash inflow on a project is likely to change each year, you can use the IRR metric. This is significant for many organizations because it provides a straightforward metric to help determine whether an expenditure was or will be worthwhile.
Companies may also use IRR in the financial analysis of projects of different durations or at different time periods, or to help assess the viability of a particular project. Real estate investors also commonly use IRR metrics.

How to Calculate Internal Rate of Return
The IRR formula is expressed as:

0 (NPV) = CF0 + CF1/(1+IRR)1 + CF2/(1+IRR)2 + CF3/(1+IRR)3 + . . . +CFn/(1+IRR)n

• CF0 represents the initial cash investment
• CF1, CF2, CF3... represent negative cash flows or positive cash flows for each period
• IRR represents the project's internal rate of return
• N represents the holding periods
• NPV represents the net present value, the goal of which is zero

Calculating IRR using a financial calculator will yeild quicker, more accurate results. If issues arise with the IRR throughout the project, you may need to use a modified internal rate of return (MIRR) to more accurately understand the investment's valuation. When there's a discounted cash flow, or if the company's costs or project dividends change over time, a MIRR will provide more accurate projections.

Companies, financial analysts, and even consumers can use IRR as a tool to evaluate capital budgeting projects, as it lets them compare the anticipated rates of return over a specific duration of time, as well as variances in time value of money. As such, IRR has numerous applications, including:

• Projection: IRR can help organizations assess investment opportunities or proposed products and services that may ultimately increase revenue or reduce overhead costs, helping a company determine whether a project is worthwhile.
• Post-project analysis: Using preexisting cash flow data from a project, IRR calculations can analyze the success of a current project or investment, as well as reinvestment rates.
• Stock buyback program evaluations: IRR can help a company assess the worth of stock buyback programs. It can demonstrate whether or not buying back stock has a higher IRR than other potential uses of the funds.
• Presentations to nonfinancial stakeholders: Companies may use IRR when presenting projects to stakeholders who don’t have financial backgrounds because the metric is straightforward and often easier for laymen to understand.
• Financial decision-making: Individuals can use the IRR metric when evaluating personal finance decisions, such as whether to invest money or pay off a debt, or for comparing the value of life insurance policies using premium payments and death benefits.

Regardless of the application, higher IRR rates are generally more desirable, and if a project's IRR exceeds the minimum rate of return required by the company, known as the company’s hurdle rate, the company may take on the project. If the rate falls below the hurdle rate, a company would likely reject the project. Remember that IRR is most effective as a tool for assessing short-term projects, which are less likely to experience adjustments from changing discount rates.

Both IRR and ROI (return on investment) measure an investment’s anticipated performance, and companies may use these metrics when assessing proposed projects or budgeting for capital expenditures; however, they measure different types of project growth. There are several key differences between these metrics:

• ROI and IRR measure different types of growth. ROI represents the increase or decrease in an investment’s value over a specific period of time. It measures the total investment returns from start to completion, whereas IRR identifies the investment’s annual growth rate.
• ROI and IRR differ over longer periods of time. Although calculations of ROI and IRR may return similar results over the short term, the numbers differ when measuring longer periods of time. This is likely because accurately predicting project earnings and investment costs over long investment horizons may be challenging.
• ROI is simpler to calculate than IRR. Although financial calculators and Excel spreadsheets offer automatic calculations for IRR, the trial-and-error nature of the calculation often makes it less popular than ROI, which is simpler to calculate manually.

For this example, a small restaurant is deciding whether to buy a delivery van at a cost of $50,000. The business plans to use the vehicle for five years, during which they anticipate it generating about $10,000 in profits annually. In the sixth year, the restaurant plans to sell the van for a price of $20,000. The restaurant has a hurdle rate of seven percent. To determine if the investment is wise, the restaurant’s management team plans to use the IRR metric.

Using a financial calculator, company leaders learn that purchasing the delivery van comes with an IRR of 9.5 percent. Since the IRR is above the hurdle rate of seven percent, the restaurant would view the investment favorably.

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