What is the IRR Rule?
The internal rate of return (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 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 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 investor. Investors and firms use the IRR rule 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 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.
IRR Rule Example
Assume a company is reviewing two projects. 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 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.