Internal Rate of Return explained

Definition

The internal rate of return (IRR) is a financial metric used to evaluate the potential profitability of an investment or project.

What is an internal rate of return?

An internal rate of return represents the discount rate at which the net present value (NPV) of all cash flows associated with the investment becomes zero. In simpler terms, IRR is the rate at which an investment breaks even in terms of its initial outlay and future cash flows.

If the calculated IRR is higher than the required rate of return (or the cost of capital), it implies that the investment is expected to generate a return higher than the minimum acceptable level, which is typically viewed as favourable. Conversely, if the IRR is lower than the required rate of return, it suggests that the investment may not meet the minimum required threshold for profitability.

IRR does not explicitly account for the risk associated with an investment. It is important to conduct sensitivity analysis to assess how changes in assumptions or cash flow estimates impact the IRR.

IRR can be used to compare the potential returns of different investment opportunities. When comparing projects, the one with the highest IRR may be preferred, provided it aligns with the company’s risk tolerance.

IRR does not account for the opportunity cost of funds tied up in the investment. This can be a significant factor in decision-making.

Example of internal rate of return

ABC Company is considering an investment in a new project that requires an initial investment of £200,000, and over the next five years, the project is expected to generate the following annual cash inflows:

Year 1: £50,000
Year 2: £60,000
Year 3: £70,000
Year 4: £80,000
Year 5: £90,000

The net cash flows for each year are calculated by subtracting the initial investment from the annual cash inflows.

Year 1: £50,000 – £200,000 = -£150,000
Year 2: £60,000 – £200,000 = -£140,000
Year 3: £70,000 – £200,000 = -£130,000
Year 4: £80,000 – £200,000 = -£120,000
Year 5: £90,000 – £200,000 = -£110,000

The IRR is the discount rate that makes the net present value (NPV) of the cash flows equal to zero. ABC Company calculates the IRR to determine the project’s internal rate of return. If the calculated IRR exceeds the company’s required rate of return or hurdle rate (let’s say 10%), then the project is deemed financially viable. If the IRR is lower than the hurdle rate, the project may not be considered economically feasible.

Make the calculation easier with our handy internal rate of return calculator.