What Is IRR?
Finance is full of acronyms, such as ROI (return on investment) or EPS (earnings per share). These are statistics used to measure specific performance, such as how much a company profited on a certain investment or how well the firm did in a specific quarter.
One less common acronym is IRR, or Internal Rate of Return. IRR is a method for measuring the risk of a particular investment based on current and future values. While complex at first glance, IRR can be a useful tool for measuring changes in rates of return.
What Is the Internal Rate of Return (IRR)?
IRR is a metric used to calculate the potential returns of different investments over time.
To calculate, the IRR solves for a net present value (NPV) of zero in discounted cash flow analysis, which can help for comparison across asset classes and investments. Taking NPV to zero allows potential investments to measured against each other based on their own potential value, not the overall net value being added to the company.
IRR measures the compounded growth rate of the investment, not the overall yield.
How Is IRR Calculated?
IRR is calculated using a rather complex formula, so don’t be afraid to start up Excel or whip out a financial calculator when making a calculation. The goal of IRR is to project the growth rate of an investment based on the NPV being zero. Since NPV will be zero, IRR is helpful when comparing the expected return of different investments.
Excel has a specific IRR function to make calculating the discount rate a little easier than by hand. Financial calculators online can also be used to plug in data and determine the IRR of an investment. But to gain a deeper understanding, here are the variables that go into the equation.
- Number of time periods
- Initial investment costs
- Cash inflows for each time period
The actual formula is quite complex, which is why calculations are usually left to the computers. When measuring IRR, companies are looking for a rate of return above what they’d pay to borrow the money. A good IRR would need to produce returns greater than this hurdle rate.
Internal Rate of Return (IRR) vs Return on Investment (ROI)
ROI and IRR may sound like similar measures, but they are not interchangeable. ROI is a total return statistic — it calculates the expected returns on investment from beginning to end. On the other hand, IRR calculates the annual expected growth rate of an investment.
Over long periods of time, ROI and IRR could vary drastically, which is why both are used in different scenarios when projecting potential investment returns. The variables used to calculate each metric are different, even though they can both be used to gauge the potential profitability of various investments.
Use Cases and Examples of IRR
Since using IRR brings the NPV to zero, it’s easy for companies to compare the potential gains of a number of new investments. Because IRR calculates an annual growth rate over a specific period, it can be used in conjunction with hurdle rate to help determine whether the investment is worthwhile.
The hurdle rate is a business term referring to a company’s cost of capital. Borrowing money is never free, but different borrowers often have different obligations when it comes to repaying their debt. Without knowing a company’s (or individual’s) hurdle rate, IRR becomes fairly useless since you cannot determine whether the IRR is higher than the cost of borrowing.
The biggest benefit of using IRR is the ability to compare different types of investments with each other in order to determine the best course of action.
For example, a company may be deliberating over a stock buyback versus the purchase of new equipment. A stock buyback is a much different type of investment than a new equipment purchase, especially when the time frame of the investment is considered. But since IRR uses an NPV of zero to calculate an annual growth rate, it’s easy to compare drastically different investments using a single rate metric.
IRR is typically used by institutions and can be applied to large projects by a business or even the government. Alternative investments also often use IRR as a tool for measuring returns for long term investments.
If a company is trying to determine whether a stock buyback or new plant investment is the ideal use of the capital, IRR could be useful. The stock buyback has a projected IRR of 12% and the company’s hurdle rate is 10% — that’s a profitable investment, but is it the best use of money?
The new plant must have an IRR above 10% to even be considered and above 12% to beat out the stock buyback plan. In order to determine the best use of capital, the company must look at the time frame of the new plant’s operation, the costs of building and acquiring equipment, and the extra profit generated by the expansion. These variables are entered into the equation and the IRR for the new plant project comes out to 10%.
At 10%, this plant investment isn’t profitable since the returns generated are roughly the same as the cost of borrowing the money. In this particular scenario, the company will shelve the plant project and move forward with the stock buyback.
Limitations of IRR
There’s no perfect metric for outlining the profitability of one investment versus another. IRR is a useful tool in that it makes certain variables equal when calculating investment returns, but there are weaknesses in the formula that must be accounted for.
For example, there are scenarios in which an investment with a lower IRR may be ideal for a company. If two investments are being compared, IRR only looks at the annual growth rate and not the total return over time. A short-term investment with an IRR of 13% may not produce the same overall return as a longer-term investment with an IRR of 10%.
This is why companies never use a single metric when determining which investment to move forward with — numerous variables must be considered, and IRR is simply one piece of hardware in the toolbox. Learn more about investing strategies in our finance section.
This material is provided for educational purposes only. It is not intended to be investment advice. It provides an illustrative overview of a mathematical concept. Any examples discussed are purely hypothetical and do not reflect any actual investments.