Internal rate of return (IRR)

Before you rely on it

What to check

Watch for cash flows that change sign more than once.

The common error

Where people go wrong with internal rate of return (IRR)

Trusting a single IRR on a project with multiple sign changes. More than one rate can satisfy the equation, the software returns whichever it found first, and the number gets quoted as if it were unique.

Worked through

Internal rate of return (IRR) in plain numbers

You invest $10,000 today and receive $3,000, $4,000 and $5,000 at the end of years one, two and three; the IRR is the rate that makes the discounted receipts equal the $10,000 outlay. Try 8%: the receipts are worth about $10,176, slightly too much. Try 9%: about $9,980, slightly too little. So the IRR is near 8.9%. If your alternative earns 6%, this project clears the bar. If you can earn 10% elsewhere, it does not. IRR turns a stream of cash flows into one annual rate, which makes projects of different sizes easy to rank at a glance.

Easily confused

Internal rate of return (IRR) and its neighbours

IRR is not the same as return on investment or CAGR. ROI is a simple ratio of gain to cost and ignores timing. CAGR links two values with no interim cash flows. IRR handles a series of cash flows at different times, and it is also different from net present value, which gives a dollar figure at a chosen discount rate. NPV answers how much value is created, and IRR answers what rate the project earns; the two can disagree on which of two projects is better, especially when sizes or timing differ.

In real decisions

Where internal rate of return (IRR) turns up

Companies rank capital projects by IRR. Private equity and real estate funds report it to investors. Individuals use it to judge annuities, rental properties and business ventures; it lets you compare a project with a required return, the hurdle rate. Spreadsheets compute it with one function. When the cash flows come at irregular dates, a variation called XIRR handles the dates.

Know the edges

Where internal rate of return (IRR) stops being reliable

IRR assumes each cash inflow can be reinvested at the same rate, which is often unrealistic for high figures. Projects with alternating positive and negative flows can have several IRRs or none; it ignores project size, so a small project with a high IRR may add less value than a large one with a lower rate; use it beside NPV and check the assumptions behind the cash flows.

Quick answers

What people ask about internal rate of return (IRR)

What is a good IRR? One above your required return, adjusted for risk. A project with an IRR of 12% clears a 10% hurdle. Compare it with alternatives and with NPV.

Why can IRR give strange results? When cash flows change sign more than once, several rates can solve the equation. In such cases NPV or the modified IRR is safer.