What is Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) Defined

Companies use Internal Rate of Return (IRR) to help inform budgeting and capital investment decisions. But what exactly is IRR and how can you apply it to your business?

In this guide, we’ll provide a simple IRR definition and an easy formula to find IRR. We’ll also provide detailed instructions on how to calculate an IRR, to help your business run smoothly.

Internal Rate of Return Definition

IRR is a financial metric used to see whether an investment is likely to be profitable.

In simple terms, IRR is the interest rate that makes the net present value (NPV) of future cash flows equal to zero. In other words, it’s the annual rate of return an investment is expected to generate.

Why does IRR matter?

When evaluating an investment, you generally have cash outflows (the initial investment) and cash inflows (the investment’s returns over time). The IRR is the interest rate that makes the present value of these cash inflows equal to the initial investment cost. So, in theory, the higher the IRR, the more profitable the investment will be.

Businesses that involve long-term capital investments, infrastructure projects, or large-scale financial decisions use IRR to measure potential returns. This metric is particularly useful if you need to compare multiple options or investment opportunities.

Is IRR the only metric that matters?

While IRR is a useful tool, companies often combine it with other metrics to get a fuller picture and make more informed financial decisions. These metrics include:

• NPV (Net Present Value): NPV measures the actual dollar value added by an investment. Many experts prefer NPV because it provides a clearer picture of value creation.
• Payback Period: IRR accounts for the time value of money, whereas the payback period measures how quickly an investment recovers its initial cost.
• Modified Internal Rate of Return (MIRR): This adjusts for IRR’s sometimes unrealistic reinvestment assumption by assuming reinvestment at the cost of capital or another realistic rate.

What kinds of businesses use IRR?

IRR can be used by both small businesses and large corporations. Essentially, any business that wants to evaluate a potential investment in new equipment or expansion opportunities can use IRR to calculate whether the project will be profitable.

Examples of small businesses that could use Internal Rate of Return Calculation include:

• Retail businesses
• Bars, restaurants, and cafés
• Healthcare and wellness businesses
• Technology and software startups
• Property developers

IRR is also widely used across businesses that require long-term capital investments. This includes industries like Private Equity & Venture Capital, Real Estate Development, Construction & Infrastructure, and Agriculture & Agribusiness.

The Internal Rate of Return (IRR) formula

The calculation of Internal Rate of Return is done using a mathematical formula.

Internal Rate of Return formula: 0 = NPV =∑ (Rt(1+IRR)t) − C0

• C0 = Initial investment (cash outflow at time 0)
• Ct = Cash flow in year t (this can be positive or negative)
• t = Time period (year 1, 2, 3, etc.).
• IRR = The discount rate that makes NPV = 0

But don’t be put off by complex mathematics! IRR can be calculated quickly using financial calculators, Excel, or specialised accounting software like QuickBooks.

An example of how to use IRR for small businesses

Imagine you own a clothing boutique and are considering opening a second location. But, before you invest, you want to analyse whether it will be profitable.

By examining your cash flow, you estimate the following:

• Initial investment (Year 0): $50,000 (for rent, renovations, stock, and marketing).
• Expected annual net cash inflows:
• Year 1: $15,000
• Year 2: $18,000
• Year 3: $20,000
• Year 4: $22,000
• Year 5: $25,000

When you run the IRR equation, this calculates IRR at 18%.

So, if your cost of capital (your loan interest rate or required rate of return) is 10%, the IRR of 18% suggests that expansion is a good idea because the return is higher than your cost. However, if your cost of capital was 20%, then the IRR of 18% would indicate the investment is not worth it.

Additional points to note about IRR

It’s important to remember that, while IRR can be useful, it does have its limitations.

• It can make assumptions: IRR assumes that all cash inflows are reinvested at the same IRR, which may not be realistic.
• It can get complicated: If future cash flows change multiple times, there may be multiple IRRs, making it hard to determine its true value.
• It ignores project scale: IRR does not account for the actual size of the investment. A smaller project with a high IRR may not generate as much total value as a larger project with a lower IRR.
• It doesn’t consider external factors: Risk, market conditions, and strategic alignment are not reflected in IRR calculations alone.

In summary, IRR is a valuable tool for evaluating investment opportunities, particularly when comparing multiple projects, but it should not be used in isolation. To make well-informed decisions, you should consider IRR alongside other financial metrics like NPV, risk factors, and business strategy.