What Is the IRR Rule?

The internal rate of return (IRR) rule is a guideline for deciding whether to proceed with a project or investment. The rule states that a project should be pursued if the internal rate of return is greater than the minimum required rate of return. That is, the project looks profitable.

On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.

What is a "good" IRR? In short, the higher the better.

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Key Takeaways

  • The IRR Rule helps companies decide whether or not to proceed with a project.
  • It states that a project is worth doing if its returns exceed the minimum required to cover costs.
  • A company may not rigidly follow the rule if the project has other, less tangible, benefits.

Understanding the 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 company. Investors and firms use the IRR rule to evaluate projects in capital budgeting, but it may not always be rigidly enforced.

A company may choose a larger project with a low IRR because it generates greater cash flows than a small project with a high IRR.

For example, a company may prefer a project with a lower IRR because it has other intangible benefits, such as contributing to 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 of the IRR Rule

Assume a company is reviewing two projects. Management must decide whether to move forward with one, both, or neither of the projects. The cash flow patterns for each are as follows:

Project A

Initial Outlay = $5,000

Year one = $1,700

Year two = $1,900

Year three = $1,600

Year four = $1,500

Year five = $700

Project B

Initial Outlay = $2,000

Year one = $400

Year two = $700

Year three = $500

Year four = $400

Year five = $300

The company must calculate the IRR for each project. 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 company can calculate IRR for each project 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 percent

IRR Project B = 5.23 percent

If the company's cost of capital is 10%, management should proceed with Project A and reject Project B.