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.
WATCH: What is Internal Rate of Return?
- 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:
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 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.