What Is the Internal Rate of Return (IRR) Rule?
The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate.
Key Takeaways
- The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate.
- The IRR Rule helps companies decide whether or not to proceed with a project.
- A company may not rigidly follow the IRR rule if the project has other, less tangible, benefits.
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Understanding the Internal Rate of Return (IRR) Rule
Essentially, the IRR rule is a guideline for deciding whether to proceed with a project or investment. The higher the projected IRR on a project—and the greater the amount it exceeds the cost of capital—the more net cash the project generates for the company. Meaning, in this case, the project looks profitable and management should proceed with it. On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.
Mathematically, IRR is the rate that would result in the net present value (NPV) of future cash flows equaling exactly zero.
Investors and firms use the IRR rule to evaluate projects in capital budgeting, but it may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.
While companies typically follow the conclusions offered by the internal rate of return (IRR) rule, other considerations—such as the size of the project and whether or not the project contributes to a larger strategy or goal of the company—may lead to management deciding to proceed with a project with a low IRR.
Example of the IRR Rule
Assume a company is reviewing two projects. Management must decide whether to move forward with one, both, or neither of the projects. Its cost of capital is 10%, The cash flow patterns for each are as follows:
Project A
- Initial Outlay = $5,000
- Year one = $1,700
- Year two = $1,900
- Year three = $1,600
- Year four = $1,500
- Year five = $700
Project B
- Initial Outlay = $2,000
- Year one = $400
- Year two = $700
- Year three = $500
- Year four = $400
- Year five = $300
The company must calculate the IRR for each project. Initial outlay (period = 0) will be negative. Solving for IRR is an iterative process using the following equation:
$0 = Σ CFt ÷ (1 + IRR)t
where:
- CF = Net Cash flow
- IRR = internal rate of return
- t = period (from 0 to last period)
-or-
$0 = (initial outlay * -1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1 + IRR)X
Using the above examples, the company can calculate IRR for each project as:
IRR Project A:
$0 = (-$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 + IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5
IRR Project A = 16.61 %
IRR Project B:
$0 = (-$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR Project B = 5.23 %
Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B.
Is Using the IRR the Same As Using the Discounted Cash Flow Method?
Yes. Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. The IRR (internal rate of return) is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Investors and firms use IRR to evaluate whether an investment in a project can be justified.
How Is the IRR Rule Used?
Essentially, the IRR rule is a guideline for deciding whether to proceed with a project or investment. So long as the IRR exceeds the cost of capital, the higher the projected IRR on a project, the higher the net cash flows to the company. On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.
Will Firms Always Follow the IRR Rule?
The IRR rule may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR, as long as it still exceeds the cost of capital, because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition. Ultimately, companies consider a number of factors when deciding whether to proceed with a project. There may be factors that outweigh the IRR rule.
FAQs
IRR is the rate of interest that makes the sum of all cash flows zero, and is useful to compare one investment to another. In the above example, if we replace 8% with 13.92%, NPV will become zero, and that's your IRR. Therefore, IRR is defined as the discount rate at which the NPV of a project becomes zero.
What is internal rate of return PDF? ›
The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero.
What is the rule of IRR? ›
The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate. The IRR Rule helps companies decide whether or not to proceed with a project.
What is the rule for IRR? ›
The IRR rule states that if the IRR on a project or investment is greater than the minimum RRR—typically the cost of capital, then the project or investment can be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.
How do you solve IRR steps? ›
How to calculate IRR
- Select two estimated discount rates. Before you begin calculating, select two discount rates that you'll use. ...
- Calculate the net present values. Using the two values you selected in step one, calculate the net present values based on each estimation. ...
- Calculate the IRR.
Inter-Rater Reliability Methods
- Count the number of ratings in agreement. In the above table, that's 3.
- Count the total number of ratings. For this example, that's 5.
- Divide the total by the number in agreement to get a fraction: 3/5.
- Convert to a percentage: 3/5 = 60%.
Companies use IRR to determine if an investment, project or expenditure was worthwhile. Calculating the IRR will show if your company made or lost money on a project. The IRR makes it easy to measure the profitability of your investment and to compare one investment's profitability to another.
Why is it called internal rate of return? ›
Internal rate of return (IRR) is a method of calculating an investment's rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or financial risk.
What is IRR and its advantages? ›
The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration. The IRR provides any small business owner with a quick snapshot of what capital projects would provide the greatest potential cash flow.
Is IRR easy to understand? ›
The textbook definition of IRR is that it is the interest rate that causes the net present value to equal zero. Although the IRR is easy to calculate, many people find this textbook definition of IRR difficult to understand. Fortunately there's a more intuitive interpretation of IRR.
IRR Calculation Complexities
The IRR formula can be very complex depending on the timing and variances in cash flow amounts. Without a computer or financial calculator, IRR can only be computed by trial and error.
What is a good IRR rate? ›
In the world of commercial real estate, for example, an IRR of 20% would be considered good, but it's important to remember that it's always related to the cost of capital. A “good” IRR would be one that is higher than the initial amount that a company has invested in a project.
What is a good IRR score? ›
60-. 74 is good; and . 75 and higher is excellent (Hallgren, 2012). Of the studies that have evaluated IRR, the findings have varied.
Can an IRR be negative? ›
Negative IRR occurs when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment. In this case, the investing entity will experience a negative return on its investment.
What does a 12% IRR mean? ›
Internal rate of return (IRR) is a financial metric used to measure the profitability of an investment over a specific period of time and is expressed as a percentage. For example, if you have an annual IRR of 12%, that means you have 12% more of something than you did 12 months earlier.
What does IRR of 30% mean? ›
What's an IRR of 30% Mean? An IRR of 30% means that the rate of return on an investment using projected discounted cash flows will equal the initial investment amount when the net present value (NPV) is zero. In this case, when the time value of money factors are applied to the cash flows, the resulting IRR is 30%.
Why IRR is the best method? ›
IRR is the best method to evaluate the economic side of an investment, because it allows a good comparison with other investment projects and financial alternatives (bank account, stocks, real estate): If the initial cash outflow occurs at time 0, it is represented by the interest rate r.
What factors affect IRR? ›
In addition to the portion of the metric that reflects momentum in the markets or the strength of the economy, other factors—including a project's strategic positioning, its business performance, and its level of debt and leverage—also contribute to its IRR.
How do you calculate IRR quickly? ›
So the rule of thumb is that, for “double your money” scenarios, you take 100%, divide by the # of years, and then estimate the IRR as about 75-80% of that value. For example, if you double your money in 3 years, 100% / 3 = 33%. 75% of 33% is about 25%, which is the approximate IRR in this case.
What is IRR stands for? ›
IRR stands for internal rate of return. It measures your rate of return on a project or investment while excluding external factors. It can be used to estimate the profitability of investments, similar to accounting rate of return (ARR).
Internal Rate of Return (IRR) is one such technique of capital budgeting. It is the rate of return at which the net present value of a project becomes zero. They call it 'internal' because it does not take any external factor (like inflation) into consideration.
What are the two types of IRR? ›
Two such types of IRRs are Project IRR and Equity IRR. Many people believe the two terms to mean the same thing, and thus, use them interchangeably. However, the two terms are very different. Hence, it is extremely crucial to understand the differences between Project IRR and Equity IRR.
What are the basic problem of IRR? ›
Limitations Of IRR
It ignores the actual dollar value of comparable investments. It does not compare the holding periods of like investments. It does not account for eliminating negative cash flows. It provides no consideration for the reinvestment of positive cash flows.
Why IRR is calculated? ›
Why IRR Is Important. The IRR helps managers determine which potential projects add value and are worth undertaking. The advantage of expressing project values as a rate is the clear hurdle it provides. As long as the financing cost is less than the rate of potential return, the project adds value.
What is a 25% IRR? ›
Using a simple calculation, investors would need to triple the value of their investment over 5 years in order to earn at 25% IRR. Therefore, if a $10 million equity investment is made, the investor would need to realize $30 million after five years in order to realize the target IRR of 25%.
What is a good IRR value? ›
In the world of commercial real estate, for example, an IRR of 20% would be considered good, but it's important to remember that it's always related to the cost of capital. A “good” IRR would be one that is higher than the initial amount that a company has invested in a project.
What does a 30% IRR mean? ›
What's an IRR of 30% Mean? An IRR of 30% means that the rate of return on an investment using projected discounted cash flows will equal the initial investment amount when the net present value (NPV) is zero. In this case, when the time value of money factors are applied to the cash flows, the resulting IRR is 30%.
What is IRR and NPV? ›
What Are NPV and IRR? Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.
Is a 12% IRR good? ›
An excellent acceptable IRR for a multifamily deal ranges from 12% to 15%. The IRR is the rate needed to convert the sum of all future uneven cash flows (cash flow, sales proceeds, and principal paydown) to equal the equity investment.
What does IRR of 15% mean? ›
The 15% IRR over 5 years would produce $1.15 for each invested dollar, but as the interest compounds over a longer timespan, that $1.15 grows to a 2.0 equity multiple for a $2 return on each invested dollar. The investment with a lower IRR had a higher equity multiple, which means it created more wealth.
Unlevered Returns: 6%-11%
The target unlevered IRR on a real estate deal, or the target IRR without the use of debt, will generally fall somewhere between about 6% on the low end, and about 11% on the high end for most real estate deals with a projected hold period of somewhere between five and ten years.
