# What is IRR?

1 min read by Rachel Carey Last updated April 30, 2024

## What is IRR?

The acronym IRR is short for The Internal Rate of Return — a financial metric that tells you if an investment is favorable and by what margin. It represents the annualized rate of return at which the net present value (NPV) of positive and negative cash flows from an investment or project equals zero.

In simpler terms, IRR is the discount rate at which an investment breaks even, meaning the total present value of cash inflows equals the total current value of cash outflows. As the inverse of the compound interest rate, IRR measures the rate at which an investment is anticipated to generate a return, making the NPV of future cash flows equivalent to the initial investment costs.

Investments and projects with higher IRRs are typically seen as more desirable because they indicate higher potential profitability or return on investment (ROI). When comparing investment opportunities, the one with the highest IRR is typically preferred, assuming the factors at play are equal.

## Are IRR and ROI the same?

IRR and ROI are terms that are sometimes confused.

While internal rate of return (IRR) and return on investment (ROI) focus on returns and act as performance measures, they differ in many aspects. The table below summarizes their differences:

Calculation Method

IRR:

• IRR is a percentage representing the rate at which the net present value (NPV) of cash flows becomes zero.

• It is calculated using complex mathematical formulas.

• Calculations often require trial and error and sometimes specialized software.

ROI:

• ROI is a percentage measuring the return of an investment relative to its cost.

• It is a straightforward calculation that divides an investment's net income by its cost.

Accounting for the Time Value of Money

IRR:

• IRR considers the time value of money, i.e., how it changes over time due to inflation and other factors.

• It provides a more accurate picture of an investment's profitability by considering future cash flows.

ROI:

• ROI does not directly consider the time value of money.

• It gives a basic return calculation relative to the initial investment without considering the timing of cash flows.

Complexity

IRR:

• IRR calculations can be complicated, especially for projects with unconventional cash flow patterns.

• It might require specialized knowledge or software to compute accurately.

ROI:

• ROI is simpler to calculate and interpret.

• It's widely used because of its simplicity.

Interpretation

IRR:

• IRR indicates the annualized rate of return at which an investment breaks even.

• A higher IRR suggests a potentially more profitable investment.

ROI:

• ROI represents the efficiency of an investment generating profit.

• A higher ROI indicates a more efficient use of resources.

## How is IRR calculated?

IRR is a way to calculate the profitability of an investment relative to the total investment period. Effectively, calculating IRR is similar to calculating NPV as it determines the discount rate (the rate of expected investment earnings) that would make the NPV equal to zero. But how is IRR calculated?

Here are the steps to calculate the IRR for an investment:

1. List cash flows: Identify all the cash flows associated with the investment, including the initial investment (often negative), future earnings (positive), and expenses (negative).

2. Calculate the NPVs: Using the formula below, calculate the NPV at the start and the projected NPV at a certain point in the investment, e.g., three years from the initial NPV.

The NPV formula is as follows:

NPV = ⨊(P/ (1+i)t ) – C

NPV = Net Present Value

P = Net Period Cash Flow

i = Discount Rate (or rate of return)

t = Number of time periods

C = Initial Investment

3. Guess an IRR: Start with a reasonable guess for the IRR. Common starting guesses are 10% and 15%.

4. Iterative calculation: Using the guessed IRR, calculate the NPV. If the NPV is close or equal to zero, you've found your IRR. If not, adjust your guess and recalculate.

5. Refine the guess: Continue refining your guess and recalculating until you find the IRR that makes the NPV nearly equal to zero. This is your Internal Rate of Return.

This method can be time-consuming if done manually, so most people use financial calculators or spreadsheet software like Excel to perform these calculations efficiently. Excel performs the iterations for you with its IRR and XIRR functions, provided you supply the relevant data (e.g., cash flows and dates or periods) in an organized set.

## What are the pros and cons of IRR?

The pros of IRR

The advantages of using IRR include:

• IRR considers the value of money over time: IRR takes into account that money changes value over time. For instance, it recognizes that getting money in the future isn't as good as getting it today because of factors like inflation.

• It offers an easy way to compare investments: IRR gives us a percentage to compare different investments. If you have a few investment options for your portfolio, you can use IRR to see which will likely make you the most money. It's like a scoring guide that rates different projects, helping you to make the best choice.

• IRR looks at the whole picture: Unlike other metrics, IRR looks at all the money you'll make and spend throughout the investment period. It doesn't focus on one aspect but considers the big picture of cash flow over time.

• IRR offers a clear decision-making rule: IRR provides a clear rule for decision-making in investment analysis. If the IRR is higher than your anticipated rate of return, the investment is probably a good idea. It simplifies the decision-making process by showing which investment or project is more likely to be profitable.

The cons of IRR

IRR does have its disadvantages. They are outlined below:

• IRR is complex and challenging to calculate: IRR involves complex math requiring trial and error or special tools. This makes it tricky for people without advanced math skills. Additionally, you might get misleading results if you make a calculation mistake.

• Some projects can have multiple IRRs: Sometimes, a project can have multiple IRRs, especially with factors like unconventional cash flows. This confuses the decision-making process because you're unsure which IRR to trust. It's like a road with many confusing turns, making it challenging to know the best one to take.

• IRR is potentially misleading regarding reinvestment: IRR assumes that cash generated from an investment can be reinvested at the same rate. This might not be true in real life and can make IRR overly optimistic about profitability.

• IRR ignores project scale: IRR doesn't consider the scale of an investment, only the percentage of return. This means that a  lemonade stand and a soda company conglomerate could share an identical IRR despite the extreme difference in scale.

## Do you have a good IRR?

What is a good IRR? A good IRR means an investment will earn more than it costs, giving you a decent profit.

Compare the IRR to your minimum profit expectations and similar investments. If it's higher, it's probably good. Also, consider the risks involved; a balance of high return and manageable risk usually indicates a good IRR.

Conversely, a bad IRR suggests an investment might not generate enough profit to cover costs. If the IRR is lower than your minimum profit expectations or similar investments, it's a red flag. Additionally, a high IRR in a risky investment could indicate a potentially bad choice due to the higher likelihood of losses.