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The internal rate of return (IRR) boils an investment down to a single percentage: the annual return it effectively earns. Technically, it's the discount rate at which the project's net present value is exactly zero — the break-even rate. If your IRR beats the return you require, the investment is worthwhile.
Enter the initial investment and the yearly cash flows, and the IRR appears at once.
How is it calculated?
What IRR means
IRR is the discount rate r that makes NPV = 0:
0 = −initial + Σ [cash flowₜ ÷ (1 + r)ᵗ]
There's no simple algebraic solution, so it's found by iteration — trying rates until NPV hits zero. The result is the annualized return the investment delivers, given its cost and cash-flow timing.
How to use it
Compare the IRR to your hurdle rate — the minimum return you require (or your cost of capital): - IRR > hurdle rate: the investment clears your bar — accept. - IRR < hurdle rate: it doesn't earn enough — reject.
A project returning 45,000 a year for three years on a 100,000 outlay has an IRR of about 16.65% — so it's worthwhile if you require less than that.
IRR vs NPV
They're two views of the same analysis. NPV gives a value in money at a chosen rate; IRR gives a rate independent of any chosen discount rate. IRR is intuitive for comparing to a required return, but NPV is better when comparing projects of different sizes (a high IRR on a tiny project may create less total value than a modest IRR on a large one).
A caveat
IRR assumes interim cash flows are reinvested at the IRR itself, which can flatter high-IRR projects. For unusual cash-flow patterns (sign changes), a project can even have multiple IRRs. When in doubt, cross-check with NPV.
Worked example
You invest 100,000 and receive 45,000 at the end of each of the next three years. To find the IRR, you look for the rate that makes the discounted cash flows exactly equal the 100,000 outlay. That rate is about 16.65%: at 16.65%, 45,000 ÷ 1.1665 + 45,000 ÷ 1.1665² + 45,000 ÷ 1.1665³ ≈ 100,000, so NPV is zero. It means the investment effectively earns 16.65% a year. If your required return is 10%, this comfortably clears the bar — consistent with its positive NPV at 10% (+11,908).
FAQ
How is IRR calculated?+
IRR is the discount rate that makes an investment's NPV zero. There's no direct formula, so it's found by iteration — trying rates until the discounted cash flows equal the initial cost. The tool does this for you.
What is a good IRR?+
One above your hurdle rate — the minimum return you require or your cost of capital. If the IRR exceeds it, the investment is worthwhile; if not, it isn't. There's no universal "good" number.
What is the difference between IRR and NPV?+
NPV gives a value in money at a chosen discount rate; IRR gives a single rate independent of any chosen rate. IRR is easy to compare to a required return; NPV is better for projects of different sizes.
Can an investment have more than one IRR?+
Yes — if the cash flows change sign more than once (e.g. outflows after inflows), there can be multiple IRRs. In those cases, NPV is the more reliable measure.
What does IRR assume about reinvestment?+
That interim cash flows are reinvested at the IRR itself, which can overstate the return on high-IRR projects. For a more conservative view, cross-check with NPV or a modified IRR.
If IRR is above my discount rate, is NPV positive?+
Yes — when your discount rate is below the IRR, NPV is positive; above it, negative; equal to it, zero. The two measures are consistent views of the same cash flows.