Internal rate of return calculator

Our Internal Rate of Return (IRR) calculator helps you determine the profitability of investments or projects.

Ian Hawkins

Page written by Ian Hawkins. Last reviewed on July 12, 2024. Next review due April 1, 2025.

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What is IRR?

IRR, or Internal rate of return, is a financial metric used to assess the profitability of an investment. It represents the annualized rate of return at which the net present value (NPV) of all cash flows from the investment equals zero. In simpler terms, IRR is the rate at which an investment breaks even, considering both the size and timing of cash flows.

How to calculate IRR?

The Internal Rate of Return (IRR) is a metric used to assess how profitable an investment or project will be. It requires cash flow details like initial investments, profits, and losses. IRR represents the discount rate that sets the net present value (NPV) of all cash flows to zero. You can compute IRR using Swoop’s IRR financial calculator or spreadsheets. Another popular method involves using the XNPV function in spreadsheets to determine the present value of future cash flows. The IRR itself is the rate where NPV equals zero. To use the calculator above, input the following values:

  • Initial investment: The initial amount of capital invested.
  • Investment return (including initial): The total cash flows generated by the investment, including the initial investment and any subsequent returns.
  • Time period: The duration over which the investment generates returns, typically expressed in years.

Example:

The Internal Rate of Return (IRR) is a key measure used to gauge how profitable an investment or project is. It’s like a benchmark that tells you the rate of return the investment is expected to generate over its lifetime. Imagine you’re considering putting money into a project that requires an initial investment of $100,000. Over the next five years, you expect it to bring in the following cash flows:

  • Year 1: $30,000
  • Year 2: $35,000
  • Year 3: $25,000
  • Year 4: $20,000
  • Year 5: $15,000

To figure out the IRR for this investment, you use a financial calculator or a tool like Excel:

  1. You punch in the initial outlay as a negative number:  -100,000
  2. Then, you enter each year’s cash flow as a positive number: 30,000, 35,000, 25,000, 20,000, 15,000

After crunching the numbers, you’d find that the IRR for this project is around 10%. This percentage represents the annual rate of return the investment is expected to earn. If the IRR is higher than your company’s cost of capital or the rate of return you could get elsewhere, then it’s likely a worthwhile investment.

In a nutshell, IRR helps you weigh different investment opportunities and decide which ones are likely to give you the best bang for your buck.

IRR uses:

IRR is commonly used by investors and businesses to assess the attractiveness of investment opportunities, compare competing projects and make informed decisions about capital allocation. It provides a standardized method for evaluating the potential returns of different investments, taking into account the time value of money. 

  1. Investment decision-making: IRR is essential for assessing investment opportunities. It helps businesses figure out if a project makes sense financially by comparing expected returns with the cost of capital. Generally, projects with higher IRRs are preferred because they offer better returns on the initial investment.

  2. Capital budgeting: Companies use IRR to prioritize their capital spending. By calculating IRR for different projects, they can decide where to allocate funds to maximize returns and make sure they’re using their resources effectively.

  3. Performance evaluation: IRR acts as a yardstick for ongoing projects. It lets businesses track and evaluate whether a project is meeting its financial goals. By comparing actual IRR with projected values, companies can spot any discrepancies and take necessary actions.

  4. Project comparison: When businesses have several project options, IRR provides a standardized way to compare their profitability. It helps in selecting the most profitable project based on its risk and return potential.

  5. Strategic decision-making: IRR guides strategic moves like expansions, acquisitions, or launching new products. By estimating potential returns using IRR, businesses can confidently make decisions that align with their growth strategies.

In essence, IRR is a versatile tool that supports strategic financial decisions, enhances how capital is managed, and ensures investments contribute positively to a company’s bottom line and future growth.

Limitations of IRR:

One limitation is that it assumes reinvestment of cash flows at the calculated IRR, which may not always be feasible. Additionally, IRR may produce multiple values or no real solution in certain cases, making interpretation challenging. As with any financial metric, it is important to consider IRR alongside other factors when making investment decisions.

FAQs

Net Present Value (NPV) is another key financial metric used in investment analysis. It represents the difference between the present value of cash inflows and the present value of cash outflows over a given time period. A positive NPV indicates that the investment is expected to generate profit, while a negative NPV suggests potential losses.

A 15% Internal Rate of Return (IRR) over 5 years means that the investment or project is expected to yield an annualized return of 15% on average over the 5-year period. This rate of return is used to assess the attractiveness of the investment compared to alternative opportunities.

A 20% Internal Rate of Return (IRR) over 5 years indicates a higher expected annualized return compared to the previous example. It suggests that the investment is projected to generate a 20% return on average per year over the 5-year duration.

A 12% Internal Rate of Return (IRR) signifies the expected annualized return on an investment or project. It indicates that the project is anticipated to yield a 12% return on average each year over its lifetime. This rate is used by businesses to gauge whether an investment is worthwhile based on its profitability potential.

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