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IRR (internal rate of return)

Also called: IRR, internal rate of return

The discount rate at which a project's NPV is zero. Useful as a summary, misleading when ranking projects of different size or timing.

IRR (internal rate of return) is the discount rate at which a project's NPV is exactly zero. Read it as the yearly return the project earns on the money tied up in it. There is no simple formula: it is found by trial, raising or lowering the rate until the discounted cash flows cancel out, which is what a spreadsheet's IRR function does.

For an ordinary project (money out first, money in later) IRR and NPV agree on the yes-or-no question: IRR above the hurdle rate means a positive NPV at that rate. That makes IRR a handy one-line summary for people who think in percentages, and a quick way to see how much room a bet has before it stops paying.

It misleads when choosing between options. IRR is a percentage, so it can't see size: a small bet with a high IRR can add far less value than a big one with a slightly lower IRR. It also ignores when the money comes, and cash flows that change sign more than once can have several IRRs or none. Decide with NPV and show IRR beside it.

Example

Klasna's developers can build one of two features this year. Lesson reminders cost 200,000 UAH and bring 180,000 and 120,000; the maths mock-exam mode costs 1,200,000 and brings 300,000, 600,000, 800,000 and 800,000.

Bet
IRR
NPV at 25%, UAH
Reminders
34.58%
20,800
Mock exams
31.26%
161,280

Check for the reminders: 180,000 ÷ 1.3458 + 120,000 ÷ 1.3458² ≈ 133,750 + 66,250 = 200,000, so NPV is zero at 34.58%. Ranked by IRR, the reminders win; in money, the mock exams add 161,280 ÷ 20,800 ≈ 7.75 times as much value. With one team and one slot, NPV decides.

Common mistakes

  • Ranking competing bets by IRR. It ignores size; compare NPVs when only one option can be done.
  • Reading IRR as a guaranteed return. It is a property of the forecast, not a promise; a delay or a cost overrun moves it.
  • Comparing IRR with the wrong bar. A 27% IRR beats a 25% company rate and fails a 40% hurdle for a new market.
  • Trusting it for unusual cash flows. When money goes out again later (a relaunch, a big repair), there can be several IRRs or none.
  • Showing IRR without NPV. Percentages don't add up across a portfolio; money does.

Learn it in the course