Understanding What is IRR (Internal Rate of Return)

Throughout my college education and my career, I’ve encountered IRR many times and it honestly has always been somewhat… unintuitive. While I know that it is one of the most important performance metrics in the finance and investment world, I still struggle at times to grasp what it means intuitively and the implications for investors when analyzing performance metrics like IRR.

That said, I’ve been seeking to understand what is IRR, so here is my attempt at writing down my findings and demystifying IRR.

What is NPV

Before we understand what is IRR, we need to first understand Net Present Value (NPV). Let’s first talk about one of the most important concepts of finance – the time value of money.

The time value of money essentially means that a dollar today is worth more than the future because a dollar today can be invested and earn a return.

If you have the option now to receive:

• Option A $100 today or
• Option B $110 in 5 years

Which would you pick?

Assuming that you can invest that $100 at 5% compounded annually, you can have $127.63 in 5 years.

Compared to the other option of getting $110 in 5 years, you would clearly pick option A. That is the time value of money, a dollar today is worth more than the future. The other thing to account for is inflation, as it erodes the value of your dollar, so getting the dollar now is worth more.

NPV Explained

The Present Value of an investment is basically what an investment is worth based on the projected cash flow in today’s terms. So following the previous example, the PV of $127.63 in 5 years is $100 when you compound $100 at 5%.

The Net Present Value (NPV) is just the difference between the present value of cash inflows and outflows over a period of time. In this case, the NPV is $0, because $100 (PV of $127.63) – $100 (your initial investment) = $0

Let’s explore this further with some examples:

Example 1: Simple Investment

• Scenario: You have the opportunity to invest $1,000 today in a project that will return $1,100 in one year.
• Assumptions:
  • Your required rate of return (discount rate) is 5%.
  • No inflation.
• Calculation:
  • Present Value of Future Cash Flow: $1,100 / (1 + 0.05)¹ = $1,047.62
  • NPV = Present Value of Future Cash Flow – Initial Investment = $1,047.62 – $1,000 = $47.62
• Interpretation: Since the NPV is positive, this investment is expected to generate a return greater than your required rate of return.

Example 2: Project Evaluation

• Scenario: A company is considering investing in a new machine that costs $100,000.
• Expected Cash Flows:
  • Year 1: $30,000
  • Year 2: $50,000
  • Year 3: $60,000
• The projected Cost of Capital: 10%
• Calculation:

$$\mathrm{NPV}=\frac{30000}{{\mathrm{(1}+\mathrm{0.10)}}^1}+\frac{50000}{{\mathrm{(1}+\mathrm{0.10)}}^2}+\frac{60000}{{\mathrm{(1}+\mathrm{0.10)}}^3}–100000$$
$$\mathrm{NPV}=27272.73+33057.85+37593.98–100000$$
$$\mathrm{NPV\; \approx \; \$12,430.84}$$

• Interpretation: Since the NPV is positive, the investment in the new machine is expected to be profitable, as its rate of return is greater than its cost of capital and it generates more value than its initial cost when considering the time value of money.

What is IRR?

Now that we understand NPV, we can dive into the concept of IRR—Internal Rate of Return. While it might seem complicated at first glance, IRR is essentially the discount rate that makes the NPV of an investment equal to zero.

Think of IRR as the answer to the question: What rate of return do I need to earn on my investment to generate the expected cash flows?

IRR Explained Intuitively

Let’s break it down with an example:

Suppose you’re considering an investment that requires an upfront cost of $10,000 today. This investment will generate cash inflows over the next five years as follows:

• Year 1: $1,000
• Year 2: $3,000
• Year 3: $2,000
• Year 4: $4,000
• Year 5: $5.000

After running the numbers on Excel, you calculate the IRR to be 12.01%. What does this mean?

It means that if you were to deposit $10,000 in a bank account earning 12.01% annually, you would be able to withdraw the cash flows exactly as outlined above:

Table of assumed returns using the calculated IRR %

Beginning	IRR return (12.01%)	Deposit/Withdrawal	Ending
		$10,000.00	$10,000.00
$10,000.00	$1,200.58	($1,000.00)	$10,200.58
$10,200.58	$1,224.66	($2,000.00)	$9,425.23
$9,425.23	$1,131.57	($3,000.00)	$7,556.80
$7,556.80	$907.25	($4,000.00)	$4,464.06
$4,464.06	$535.94	($5,000.00)	($0.00)

By the end of the fifth year, your account balance would be exactly zero. This shows that the IRR represents the return your initial investment is generating taking into account the projected cash flow from the investment. In other words, as PropertyMetrics stated, it is the percentage rate earned on each dollar invested for each period it is invested.

Why Does IRR Matter?

Imagine you’re presented with two investment opportunities. Both promise to make you money with a list of various projected cash flows, but which one is truly better? This is where knowing what is IRR becomes incredibly valuable.

Here’s why understanding what is IRR matters:

• Decision Making: IRR is your compass. If your investment’s IRR is higher than your “required rate of return” (the minimum return you’re comfortable with, considering factors like inflation and risk), it signals that the investment has the potential to meet or exceed your expectations.
• Comparing Opportunities: Let’s say you’re torn between investing in a new business venture or buying rental property. Both might seem appealing, but calculating the IRR for each helps you see which option offers the potentially higher return on your investment, all else equal.
• Setting Realistic Expectations: IRR helps you understand what kind of returns you can realistically expect from your investment. This prevents unrealistic expectations and disappointment down the line.
• Measuring Performance: After you’ve made an investment, tracking its IRR over time helps you measure its actual performance against your initial projections. This allows you to see if the investment is on track and make adjustments if needed.

In essence, IRR provides a standardized way to evaluate investment opportunities, making it easier to make informed decisions and maximize your returns.

What is IRR: Example

Let’s revisit the machine investment from earlier, but now calculate its IRR.

Scenario:
The machine costs $100,000 today and generates cash flows as follows:

• Year 1: $30,000
• Year 2: $50,000
• Year 3: $60,000

Calculation:
To compute IRR, let’s plug the numbers into Excel with this formula:

=IRR(-10000,30000,50000,60000)

After solving, we find IRR to be 12.01%.

Interpretation:
If your company’s cost of capital is 10%, the machine is a good investment because the IRR (12.01%) exceeds the cost of capital. This means that based on the assumed cash flow and outflows, the project is expected to generate a return greater than the cost of capital required to justify the investment.

How Timing Affects IRR

IRR is very sensitive to the timing of cash flow. Receiving cash sooner increases the IRR because you can reinvest that money earlier.

Example 1: Early Cash Returns
If you invest $1,000, and the returns look like this:

• $600 in Year 1,
• $500 in Year 2,
• $200 in Year 3,

The formula becomes:

$$0=-1000+\frac{600}{{(1+\mathrm{IRR})}^1}+\frac{500}{{(1+\mathrm{IRR})}^2}+\frac{200}{{(1+\mathrm{IRR})}^3}$$

The IRR comes out to about 17.21% because more cash arrives earlier than can be reinvested.

Example 2: Delayed Cash Returns
If the $1,000 investment returns are:

• $200 in Year 1,
• $500 in Year 2,
• $600 in Year 3,

The formula changes to:

$$0=-1000+\frac{200}{{(1+\mathrm{IRR})}^1}+\frac{500}{{(1+\mathrm{IRR})}^2}+\frac{600}{{(1+\mathrm{IRR})}^3}$$

Now, the IRR drops to about 12.21% because most of the cash comes later.

Although the total dollar cash flow is the same for both examples, example 2’s bigger cash flow of $600 came at a later time than example 1. This means that this cash flow is discounted more heavily due to the time value of money.

Why IRR is Not Perfect

While IRR is a key performance metric in many finance and investment decisions, it is far from perfect and should be used in conjunction with other metrics to make an informed decision.

1. Ignores the Scale of Investments
   • IRR does not account for the size of the investment. A smaller project with a high IRR may not generate as much absolute value as a larger project with a slightly lower IRR. This can be misleading when comparing opportunities of vastly different sizes.
2. Multiple IRRs for Non-Conventional Cash Flows
   • When cash flow patterns alternate between positive and negative (e.g., in projects with multiple phases of funding and payback), there can be more than one IRR, leading to confusion about which rate to use.
3. Focus on Percentage Returns
   • IRR is a percentage-based metric, meaning it tells you the rate of return but not the absolute dollar amount of value created. An investor might prefer a lower IRR on a larger investment if it generates significantly more value.
4. No Consideration of Time
   • While IRR inherently accounts for the time value of money, it doesn’t directly provide insight into how quickly capital is deployed or recovered. Two projects with the same IRR can have vastly different cash flow timelines.
5. Lack of Risk Analysis
   • IRR doesn’t explicitly address the risk associated with the underlying investment. Two projects might have the same IRR, but if one is much riskier than the other, the investor needs to consider risk-adjusted returns.

Using IRR in Conjunction with Other Metrics

To address its shortcomings, IRR is best used alongside other financial metrics, creating a more holistic view of an investment’s performance.

1. MOIC (Multiple on Invested Capital)
   • MOIC measures the total return on investment as a multiple of the capital deployed. Unlike IRR, it focuses on the absolute value created, making it a good complement when assessing whether the returns justify the investment size.
     • Example: A project might have an IRR of 20% and an MOIC of 2x, indicating the investment doubled in value.
2. Times Capital Returned
   • This metric measures how many times the invested capital (including uncalled capital) has been returned to the investor, either through distributions, profits, or asset sales. It’s especially useful in private equity or venture capital, where there’s a possibility that not all capital is called and invested.
     • Example: If $1M was invested and $3M was returned, the times capital returned would be 3x.
3. NPV (Net Present Value)
   • NPV provides the absolute dollar value created after accounting for the time value of money and the cost of capital. It’s particularly useful when comparing projects of different scales because it shows the net benefit in monetary terms, regardless of the IRR percentage.
4. Percentage of Capital Put to Work
   • Measuring how much of the committed capital has been deployed gives insight into the efficiency of capital allocation. A high IRR might be achieved on only a small portion of the committed capital, which can be misleading in terms of overall performance.
5. Speed of Capital Deployment and Recovery
   • How quickly capital is put to work and recovered is crucial, especially for investors focused on liquidity or reinvestment opportunities. Faster recovery of capital reduces risk exposure and increases flexibility for future investments.
6. Timing of Distributions and Harvesting
   • The timing of cash flows matters. Even if the IRR is high, delays in distributions can negatively impact an investor’s ability to reinvest or meet liquidity needs. Evaluating the timing alongside IRR provides a clearer picture of performance.

Conclusion

IRR is undeniably one of the most widely used metrics in the world of finance and investments, but it’s far from perfect. While it gives us a quick way to evaluate potential returns, relying solely on IRR can lead to misleading conclusions. The reality is, that no single metric can capture the full story of an investment.

That’s why it’s crucial to understand what is IRR and use it alongside other tools like NPV, MOIC, or TCR. Each of these metrics adds a unique layer of insight, helping you understand the bigger picture—whether it’s the absolute dollar value created, the timing of cash flows, or the risks involved.

At the end of the day, investments aren’t just about percentages—they’re about making decisions that align with your goals, risk tolerance, and resources. So, while IRR can be a powerful guide, it’s just one piece of the puzzle. The key is to approach investment decisions with a balanced and holistic view, using all the tools at your disposal to make smarter, more informed choices.

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The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. If you have questions pertaining to your individual situation you should consult your financial advisor.