What is the Internal Rate of Return (IRR)? Meaning, Formula & Why It Matters

Suppose you are an entrepreneur, evaluating two potential projects: one involves launching a new line of eco-friendly home products, and the other focuses on expanding your existing retail store. Each project requires a significant investment and prom ises varying cash flows over time. You need a reliable financial metric to determine which venture offers better profitability. That is where the Internal Rate of Return (IRR) comes in handy.

Let’s discuss IRR’s meaning, how it is computed, and more.

What is IRR?

The Internal Rate of Return (IRR) measures investment or project profitability. It represents the annualised effective compounded return rate that can be earned on invested capital. It considers the time value of money and the timing of cash flows.

How Does IRR Work?

The Internal Rate of Return (IRR) is the discount rate at which an investment’s net present value (NPV) equals zero. Put simply, it is the rate at which the present value of expected future cash flows matches the initial outlay.

For example, consider a project that requires an initial investment of ₹100,000. Over the next five years, it generates cash flows of ₹30,000, ₹25,000, ₹20,000, ₹18,000, and ₹15,000, respectively. To find the IRR of this project, we adjust the discount rate until the NPV of these cash flows equals zero. In this case, the IRR might be calculated to be 12%.

A higher IRR indicates a more attractive investment, as it suggests a higher return on the initial investment.

Formula for Internal Rate of Return

To compute IRR manually, you can use the following formula:

0 = NPV = ∑ (Ct / (1 + IRR)^t) - C₀

Where:

• Ct = Net cash inflow during period t
• C₀ = Initial investment (a negative cash flow)
• t = Time period
• IRR = Internal rate of return (the rate to solve for)

This equation is solved either via trial-and-error, financial calculators, Excel functions, or computational software.

How to Calculate IRR in Excel?

To compute IRR using Excel, consider the following steps:

• Step 1: Enter your cash flows in a single column or row. For example, you can use cell range B1:B5 for cash flows.
• Step 2: In a blank cell where you want the IRR result to appear, type =IRR(.
• Step 3: Select the range of cash flows using the cursor or by typing the cell range. For example, B1:B5.
• Step 4: After selecting the range, close the function with a closing parenthesis ) and press Enter.
• Step 5: Excel will calculate and display the IRR percentage as a decimal. Format it as a percentage for clarity.

Let’s say you have invested ₹1,00,000 in a project and expect to receive ₹30,000, ₹35,000, ₹40,000, and ₹45,000 over the next four years. In Excel, enter these values as -100000, 30000, 35000, 40000, 45000 in cells A1 to A5. Then, type =IRR(A1:A5) in another cell. Press Enter, and Excel will show your IRR, helping you understand your investment’s potential return.

What are the Key Components in the IRR Formula?

The four main components of IRR are:

1. Net Present Value

NPV helps determine whether an investment is financially viable. It gauges the difference between the present value of cash inflows and outflows over time. NPV is discounted at a specified rate (usually the cost of capital). In the IRR formula context, NPV is set to zero because the IRR is the discount rate that makes the NPV of cash flows equal to zero.

2. Cash flow

In IRR, cash flow refers to the money moving in and out of a project or investment over time. It includes initial investment (outflow) and returns or earnings (inflows) in future years.

3. Number of periods

The number of periods in IRR refers to how long the investment lasts. It is usually measured in years, months, or quarters. Simply put, it is the total time over which cash flows (both incoming and outgoing) are considered. To calculate the IRR correctly, the timing of these cash flows must be accurate, as IRR assumes reinvestment at the same rate during all periods.

4. Initial investment

The initial investment refers to the amount of money you initially put into a project or investment. It is the upfront cost you pay to start the project, such as buying equipment, building infrastructure, or funding a business idea.

Why Does IRR Matter?

Here is why IRR is important:

• IRR allows you to assess whether a project or investment meets your required rate of return. If the IRR exceeds your cost of capital, the investment is generally considered financially viable.

• When choosing between multiple projects, IRR helps you compare them on a standardised rate-of-return basis. This lets you identify which option offers the highest potential profitability.

• IRR considers the timing of your cash flows, unlike simple return metrics. This ensures your investment evaluation reflects the real economic value of returns received at different periods.

• You can use IRR to decide whether to proceed with long-term projects. It improves resource allocation by prioritising projects that surpass your hurdle rate or cost of capital.

• A higher IRR relative to your cost of capital often indicates a safer investment. You can use IRR to gauge risk and avoid projects that offer insufficient returns for their uncertainty.

• IRR expresses profitability as a percentage, making it easier to communicate expected returns to investors, management, or partners without requiring them to interpret complex financial models or spreadsheets.

Limitations of the Internal Rate of Return

Using IRR is not always viable. Here is why:

Assumes reinvestment at IRR

IRR assumes you will reinvest all future cash flows at the same rate as the IRR itself. This is not realistic because it is rare to find other projects with exactly the same return. If actual reinvestment opportunities offer lower returns, the project’s real profitability may be overstated.

Mutually exclusive projects

When comparing mutually exclusive projects (you can only pick one), IRR might suggest a less profitable option. This is because it focuses on percentage returns, not the total value added. A project with a lower IRR might actually generate more overall profit.

Issues with value creation

IRR tells you the rate at which a project breaks even in terms of net present value, but it doesn’t show how much value it adds. Even if a project has a high IRR, it might not contribute meaningfully to your company’s overall financial goals without supporting NPV analysis.

Also, if your project has alternating positive and negative cash flows, you might see more than one IRR. This creates confusion because you won’t know which IRR to rely on.

Inaccurate project ranking

If you are trying to rank several projects, IRR can mislead you. It does not distinguish between long-term and short-term projects. A short project with a high IRR may be chosen over a long-term project with a lower IRR but greater total returns, distorting your investment priorities.

Issues with evolving discount rate

IRR does not adapt well if your cost of capital changes over time. Since IRR is a single rate, it ignores the reality that borrowing costs or market expectations may shift. You could make the wrong choice if you don’t account for varying discount rates over the project’s life.

Conclusion

The IRR is essential for evaluating investment performance and capital budgeting decisions. It lets you decide based on expected annual returns, helping prioritise financially viable projects. While it has limitations, like multiple IRRs and unrealistic reinvestment assumptions, its ease of interpretation and comprehensive nature make it a favourite among analysts.