IRR
Discount rate where NPV equals zero.
What does IRR mean?
Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. It represents the annualized effective rate of return an investment is expected to generate. A higher IRR indicates a more profitable investment. IRR is widely used in capital budgeting to evaluate and compare potential investments.
How to calculate IRR
IRR is found by solving for the rate (r) in the equation: 0 = -Initial Investment + CF/(1+r)^1 + CF/(1+r)^2 + ... + CF/(1+r)^n, where CF is the cash flow per period and n is the number of periods. Since there is no closed-form solution, IRR is calculated iteratively using Newton's method. For example, if you invest $50,000 and receive $15,000 per year for 5 years, the IRR is approximately 15.24%.
FAQ
A "good" IRR depends on the type of investment and the associated risk. Generally, an IRR above the cost of capital or the required rate of return is considered acceptable. For private equity, IRRs of 20-30% are often targeted. For real estate, 8-12% is common. Always compare IRR against your hurdle rate and alternative investment opportunities.
ROI measures the total percentage return on an investment without considering the time value of money. IRR, on the other hand, accounts for the timing of cash flows and expresses the return as an annualized rate. IRR is more useful for comparing investments with different time horizons and cash flow patterns.
Yes. A negative IRR means the investment loses money — the total cash flows received are less than the initial investment. This indicates the project destroys value and should generally be avoided unless there are significant non-financial benefits.
IRR assumes that all cash flows are reinvested at the IRR itself, which may not be realistic. It can also produce multiple solutions for projects with alternating positive and negative cash flows. For mutually exclusive projects, NPV is generally preferred over IRR as a decision metric.
IRR is the discount rate at which NPV equals zero. If the IRR exceeds the required rate of return (discount rate), the NPV is positive, and the investment adds value. If the IRR is below the required rate, the NPV is negative, and the investment destroys value.
Related calculators
- ROI— Return relative to investment cost.
- NPV— Net present value of future cash flows.
- CAGR— Average annual growth rate.
- Compound Interest— Growth of money with reinvested interest.