What is 'IRR'
The internal rate of return (IRR) represents the interest rate in which the net present value (NPV) of a project's expected total cash flows, both positive and negative, sum to zero. The IRR of a project is used as a benchmark; if the IRR of a specific project is higher than a company's required rate of return. the firm accepts the project. If, however, the IRR of a project is calculated to be below a company's required rate of return, the company does not move forward with the project.
BREAKING DOWN 'IRR'
IRR is a metric used across many financial concentrations as a measurement for cash flow analysis. The most common way it's used is as a project-based tool, but it can also be used by investors when evaluating investments and capital acquisitions. The formula for IRR is labor-intensive and takes the initial cash outflow (P0) and sums it with all future cash flows (P1...PN), divided by the IRR and square rooted to the power of the period. The equation for IRR is as follows: 0 = P0 + P1 / (1+IRR) + P2 / (1+IRR)^2 + ... + PN / (1+IRR)^N, where N represents the last period in the sequence of cash flows.
The Importance of the IRR Benchmark
All companies seek to initiate projects with high IRRs; higher IRRs result in higher-percentage returns on investments. Therefore, IRR is used as a decision-making tool for situations that include a single project or multiple projects. If a company is evaluating a single project, it looks at the IRR and rejects or accepts the project based on the relationship between its IRR and the company's minimum required return. If a company is evaluating a group of projects, it looks at each one's IRR and chooses a combination of projects that results in the highest collective IRR. If two or more projects are mutually exclusive, meaning that choosing one bars the other from being chosen, the company accepts the project with the highest IRR.
IRR does not take into account the overall size of a project's investment or return. While IRR is an accurate benchmark for managerial decision making, company leaders should also look at the size of the dollar return when making decisions. For example, a small project might have a high IRR percentage-wise but a low dollar return. Conversely, a large project may have a smaller IRR yet have a much larger dollar return, making it an attractive investment.