What is the 'IRR Rule'
The IRR rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.
BREAKING DOWN 'IRR Rule'The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. The IRR rule is used to evaluate projects in capital budgeting, but it may not always be rigidly enforced. For example, a company may prefer a project with a lower IRR over one with a higher IRR because the former provides other intangible benefits, such as being part of a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.
Example Internal Rate or Return Rule Decision
Assume there are two projects that a company is reviewing. Management must decide whether to move forward with one, none or both of the projects. The cash flow patterns for each project are as follows:
Initial Outlay = $5,000
Year one = $1,700
Year two = $1,900
Year three = $1,600
Year four = $1,500
Year five = $700
Initial Outlay = $2,000
Year one = $400
Year two = $700
Year three = $500
Year four = $400
Year five = $300
The IRR for each project must be calculated. This is through an iterative process, solving for IRR in the following equation:
$0 = (initial outlay x -1) + CF1 / (1 + IRR) ^ 1 + CF2 / (1 + IRR) ^ 2 + ... + CFX / (1 + IRR) ^ X
Using the above examples, the IRR for each project is calculated as:
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
IRR Project A = 16.61%
IRR Project B = 5.23%
If the company's cost of capital is 10%, management should proceed with Project A and reject Project B.