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What is Internal Rate of Return (IRR)?

Internal rate of return (IRR) is the discount rate at which an investment's future cash flows have a net present value of zero. In other words, it is the annual return the project is expected to generate. If the IRR exceeds the cost of capital, the investment is considered worthwhile.

IRR answers a different question than NPV. NPV tells you how much value a project adds in today's money; IRR tells you the percentage return the project is expected to earn per year. Because it is expressed as a rate, it is easy to compare against the interest rate on a loan or the return available elsewhere.

The decision rule is to accept a project when its IRR is above the required return and reject it when it is below. The two measures can occasionally disagree when cash flows change direction more than once, which is why practitioners often calculate both. IRR is most useful as a quick, comparable rate rather than a complete picture on its own.

Example

A project costs €8,000 and is expected to return €3,000 a year for three years. Its IRR works out to about 6%, so if the business's cost of capital is 4% the project clears the hurdle, while at a 7% cost of capital it would not.

Questions

What is the difference between IRR and NPV?

NPV measures the value a project adds in today's money; IRR expresses the project's expected annual return as a percentage. NPV tells you how much, IRR tells you at what rate, and both use the same underlying cash-flow forecast.

When should a project be accepted based on IRR?

When its IRR is higher than the cost of capital or required return. If the IRR is below that hurdle, the project returns less than the money costs and should generally be declined.

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