Internal Rate of Return (IRR) Rule: Formula and Benefits

What Is the Internal Rate of Return (IRR) Rule?

The internal rate of return is a financial metric used to evaluate the profitability of potential investments. The IRR rule states that a project or investment may be worth pursuing if its internal rate of return (IRR) exceeds the minimum required rate of return, or hurdle rate. This rule can be useful for companies and investors that want to determine whether to take on a certain project or investment or to compare it with others they may be considering.

However, it also has some serious limitations. It's important to consider other benefits beyond financial ones when making investment decisions.

How the Internal Rate of Return (IRR) Rule Works

The IRR rule is a guideline for deciding whether to proceed with a project or investment, on a financial basis. Mathematically, IRR is the rate that would result in the net present value of future cash flows equaling exactly zero.

The higher the projected IRR on an investment—and the greater the amount by which it exceeds the cost of capital—the more net cash it is likely to generate and the more it may be worth pursuing. On the other hand, if the IRR is lower than the cost of capital, the rule suggests that the best course of action is to forgo the project or investment.

Businesses often use the IRR rule to evaluate projects in capital budgeting. But it may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company might prefer a project with a lower IRR because it has other potential benefits, such as contributing to a larger strategic plan or impeding competition.

A company might choose a large project with a lower IRR over a small one if it produces more cash in total.

Pros and Cons of the IRR Rule

Advantages

IRR is easy to understand and calculate with a spreadsheet. Companies and investors can compare it to other projects and investments that are under consideration.

This rule helps companies and investors consider the time value of money (TVM). This is a concept that states that a particular amount of money is worth more now than the same sum in the future. The IRR rule discounts future cash flow to its present value.

Disadvantages

The IRR doesn't consider the project's actual dollar value or irregular cash flows. If there are any irregular or uncommon forms of cash flow, the rule shouldn't be applied. If it is, it may result in flawed findings.

Another key disadvantage of the IRR rule is that it is flawed in its assumption regarding any reinvestments made from positive cash flow—notably, that they are made at the same internal rate of return. A modified internal rate of return (MIRR) is sometimes used instead as it assumes that positive cash flows are reinvested at the firm's cost of capital.

Practical Example: Applying the IRR Rule

Let's assume that a company is reviewing two projects in which it may invest its money. Management must decide whether to move forward with one, both, or neither of the projects. Its cost of capital is 10%. The cash flow patterns for each project are highlighted in the following table:

The company must calculate the IRR for each project. The initial outlay (period = 0) will be negative. Solving for IRR is an iterative process (where results for each period are summed) using the following equation. The upper case sigma (Σ) denotes summation, or creating terms for each period using the formula that follows the symbol and then adding the result for each period:

$0 = Σ [ CF_t ÷ (1 + IRR)^t ] - C₀

Where:

• CF = Net cash flow
• IRR = Internal rate of return
• t = Period (from 0 to last period)
• C₀ = The initial outlay

The formula looks like this with the terms in order. The initial outlay is multiplied by -1 because it is money being subtracted from the project:

$0 = [ initial outlay * -1 ] + [ CF₁ ÷ (1 + IRR)¹ ] + [ CF₂ ÷ (1 + IRR)² ] + ... + [ CF_X ÷ (1 + IRR)^X ]

Using the above examples, the company can calculate IRR for each project. In each term, "IRR" must be substituted with an educated guess because the only way to determine the best IRR is through trial and error:

• IRR Project A: $0 = [ (-$5,000) + $1,700 ] ÷ [ (1 + IRR)¹ + $1,900 ] ÷ [ (1 + IRR)² + $1,600 ] ÷ [ (1 + IRR)³ + $1,500 ] ÷ [ (1 + IRR)⁴ + $700 ] ÷ [ (1 + IRR)⁵ ]
• IRR Project B: $0 = (-$2,000) + $400 ÷ (1 + IRR)¹ + $700 ÷ (1 + IRR)² + $500 ÷ (1 + IRR)³ + $400 ÷ (1 + IRR)⁴ + $300 ÷ (1 + IRR)⁵

You can see how this can become manually tedious and prone to errors. Using a spreadsheet simplifies matters considerably.

Step-by-Step Guide: Calculating IRR With Spreadsheets

1. Gather your financial data, including initial outlay and periodic cash flows.
2. Open a spreadsheet program, like Excel or Google Sheets.
3. Input your cash flow values in consecutive cells (e.g., column A).
4. In a new cell, use the formula `=IRR(x:y)`, where X is the first cell with data, and Y is the last.
5. Interpret the result to determine if the project exceeds the required rate of return.

Using the same values in a spreadsheet, you can use this function:

=IRR(x:y)

Where:

• X is the first cell in a column
• Y is the last cell in the same column
• The initial outlay should be negative

The following table shows the entries and the function.

In the spreadsheet, enter the following in one cell:

=IRR(A1:A6)

And in another cell, enter:

=IRR(B1:B6)

In the spreadsheet, project A results in an IRR of 17%, and project B results in an IRR of 5%. Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B.

The Bottom Line

The IRR rule is a guiding principle for evaluating the potential of projects or investments by comparing the IRR to the required rate of return or hurdle rate. It's a straightforward and valuable tool for understanding potential returns and considering time-value benefits, but it comes with limitations. IRR does not account for actual dollar amounts or irregular cash flows. It doesn't assume reinvestments at the same rate, which can result in inaccurate assessments.

Using a balanced approach can be helpful, where IRR is used alongside other financial analyses to evaluate a project's full potential, considering both financial and strategic benefits. Using spreadsheets can create accurate IRR calculations because project decisions should consider capital cost and possible cash flows.

IRR is not always rigidly applied, and decisions may need to factor in broader strategic objectives.