Internal Rate of Return (IRR)

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Saying a project makes 20 dollars is useful, but it does not tell you whether that is a fantastic deal or a barely decent one. A bank account answers a similar question with a single, easy to compare number: its interest rate. Internal rate of return, usually shortened to IRR, gives a project or investment that same kind of number, a percentage that sums up how good its return really is.

Finding the rate that zeroes everything out

Remember the lemonade stand from net present value. It cost 50 dollars to set up, and its future cash flows were worth 70 dollars today once shrunk down using a discount rate of 8 percent, giving a positive NPV of 20 dollars.

IRR asks a different question. Instead of picking a discount rate ourselves, it asks: what discount rate would shrink those exact same future cash flows down until they are worth precisely 50 dollars today, making the NPV exactly zero? Let's say the answer turns out to be 25 percent. That 25 percent is the lemonade stand's IRR, the effective interest rate its own cash flows are quietly earning you.

Using IRR to decide

Once you have an IRR, comparing it to some other rate you care about becomes very simple:

• If the IRR is higher than what you could otherwise earn, say by leaving your money in the bank or lending it out at Interest, the project looks like the better choice.
• If the IRR is lower than that other rate, you would probably be better off skipping the project and doing the other thing with your money instead.

Because working out the exact rate that zeroes out several years of cash flows involves some tricky math, people almost always let a computer or a spreadsheet find the IRR rather than solving it by hand.

A tricky wrinkle

IRR is handy, but it has two real limits worth knowing about. First, some unusual patterns of cash flows, for example money going out, then coming in, then going out again, can produce more than one rate that zeroes out the NPV, leaving more than one possible "answer." Second, IRR is only a percentage, so it does not know how big a project actually is. A tiny project with a dazzling IRR might still create far less real value than a much bigger project with a merely solid IRR. Because of both of these wrinkles, careful decision makers usually check NPV and IRR together rather than trusting IRR alone.

Fun facts

• IRR turns any investment into one tidy percentage, which is why it shows up constantly in business plans and pitch decks, right alongside NPV.
• Companies often set a minimum acceptable IRR ahead of time, called a hurdle rate, and only move forward with projects that are expected to clear that bar.
• The word "internal" in the name is a hint about how it works: the rate comes entirely from inside the project's own cash flows, rather than being borrowed from some outside interest rate.