IRR Calculator
Enter expected cash inflows for each year (Year 1, Year 2, etc.)
IRR Decision Rule
Accept if:
IRR > Required Return
Reject if:
IRR < Required Return
Key Metrics
IRR
Rate where NPV = 0
NPV
Present value of all cash flows
Profitability Index
PV of inflows / Investment
Understanding Internal Rate of Return
What is IRR?
The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows equal to zero. It represents the expected annual rate of growth an investment is projected to generate.
IRR Formula Concept
IRR is the rate (r) that satisfies: 0 = Initial Investment + CF1/(1+r) + CF2/(1+r)^2 + ... + CFn/(1+r)^n
This equation cannot be solved algebraically and requires iterative methods.
IRR vs Other Metrics
| Metric | What It Measures | Advantage | Limitation |
|---|---|---|---|
| IRR | Rate of return | Easy to compare | Assumes reinvestment at IRR |
| NPV | Dollar value added | Shows absolute value | Requires discount rate |
| ROI | Total return percentage | Simple calculation | Ignores time value |
| Payback | Time to recover | Simple, focuses on risk | Ignores cash after payback |
When to Use IRR
IRR Works Best For:
- - Comparing projects of similar size
- - Projects with conventional cash flows
- - Capital budgeting decisions
- - Setting hurdle rates
IRR Limitations:
- - Multiple IRRs possible with unusual cash flows
- - Ignores project size (scale)
- - Assumes reinvestment at IRR rate
- - May conflict with NPV rankings
Example Analysis
Project Comparison
Project A
Investment: $100,000
Cash Flows: $30K, $35K, $40K, $45K
IRR: 15.2%
Project B
Investment: $50,000
Cash Flows: $20K, $20K, $20K
IRR: 9.7%
While Project A has a higher IRR, consider that it requires twice the investment. NPV analysis may give different rankings depending on your cost of capital.
Industry-Specific IRR Examples
Real Estate Investment Example: Rental Property
Scenario: Purchase a rental property for $250,000 with expected rental income and eventual sale.
Cash Flow Analysis:
- Year 0: -$250,000 (Purchase price + closing costs)
- Year 1: +$18,000 (Net rental income after expenses)
- Year 2: +$18,500 (Rent increase)
- Year 3: +$19,000 (Rent increase)
- Year 4: +$19,500 (Rent increase)
- Year 5: +$320,000 (Net rental + sale at $300K appreciation)
Step-by-Step IRR Calculation:
- Set NPV equation: 0 = -250,000 + 18,000/(1+r) + 18,500/(1+r)² + 19,000/(1+r)³ + 19,500/(1+r)⁴ + 320,000/(1+r)⁵
- Use iterative method (Newton-Raphson) to solve for r
- Result: IRR = 12.8%
This exceeds typical real estate hurdle rates of 10-12%, making it an attractive investment.
Startup Investment Example: Venture Capital
Scenario: Seed investment in a tech startup with multiple funding rounds and exit.
Cash Flow Analysis:
- Year 0: -$500,000 (Seed round investment for 10% equity)
- Year 1: $0 (Company in growth phase, no distributions)
- Year 2: -$200,000 (Follow-on Series A to maintain 8% equity)
- Year 3: $0 (Continued growth)
- Year 4: $0 (Preparing for exit)
- Year 5: +$2,400,000 (Exit at $30M valuation, 8% = $2.4M)
Step-by-Step IRR Calculation:
- Total invested: $700,000 over 5 years
- Set NPV equation: 0 = -500,000 + 0/(1+r) - 200,000/(1+r)² + 0/(1+r)³ + 0/(1+r)⁴ + 2,400,000/(1+r)⁵
- Solve iteratively for r
- Result: IRR = 28.4%
This meets typical VC hurdle rates of 25-30% for early-stage investments, accounting for high failure risk.
IRR vs NPV: When to Use Each
Decision Tree for Choosing Between IRR and NPV
When IRR and NPV Give Conflicting Recommendations
IRR and NPV can rank projects differently due to:
- Scale differences: A small project with high IRR vs. large project with lower IRR but higher NPV
- Timing differences: Projects with different cash flow patterns
- Reinvestment assumptions: IRR assumes reinvestment at IRR rate; NPV assumes reinvestment at discount rate
Rule of thumb: When they conflict, NPV is generally preferred as it directly measures value creation.
Real-World Case Study: IRR vs NPV Conflict
Scenario: Choose between two mutually exclusive projects (discount rate = 10%)
Project X (Small Scale)
- Investment: $10,000
- Year 1 CF: $15,000
- IRR: 50%
- NPV: $3,636
Project Y (Large Scale)
- Investment: $100,000
- Year 1 CF: $120,000
- IRR: 20%
- NPV: $9,091
Analysis: Project X has higher IRR (50% vs 20%), but Project Y creates more value ($9,091 vs $3,636 NPV). If you can only choose one, Project Y is better despite lower IRR. If you have unlimited capital, do both.
Common Hurdle Rates
Conservative
8-10%
Low-risk projects
Moderate
12-15%
Average business risk
Aggressive
20%+
High-risk ventures
Professional Tip
Use multiple metrics (IRR, NPV, Payback, PI) together for better investment decisions. IRR alone can be misleading, especially when comparing projects of different sizes or with non-conventional cash flow patterns.
Frequently Asked Questions
What is IRR and how is it used?
Internal Rate of Return (IRR) is the discount rate that makes the net present value of all cash flows equal to zero. It represents the expected annual return of an investment. If IRR exceeds your required return (hurdle rate), the investment may be worthwhile. IRR is commonly used in capital budgeting and real estate analysis.
What is the difference between IRR and ROI?
ROI (Return on Investment) measures total return as a percentage of the initial investment, ignoring the time value of money. IRR accounts for the timing of cash flows, expressing return as an annual rate. A project with 50% ROI over 5 years has a different IRR than one with 50% ROI over 2 years. IRR is more accurate for comparing investments with different timelines.
What is a good IRR for an investment?
A 'good' IRR depends on the risk and alternative investments. Conservative projects might target 8-10% IRR, average business investments 12-15%, and high-risk ventures 20%+. The investment should exceed your cost of capital (what you could earn elsewhere with similar risk). Real estate typically targets 15-20% IRR, venture capital targets 25%+.
What are the limitations of IRR?
IRR has several limitations: it can produce multiple results with unconventional cash flows, it ignores project size (scale), and it assumes reinvestment at the IRR rate. IRR may also conflict with NPV rankings when comparing mutually exclusive projects. Use IRR alongside NPV, payback period, and profitability index for better decisions.