The internal rate of return (IRR) is the discount rate that makes a project's net present value zero. It shows the project's own percentage return. If the IRR is higher than the cost of capital, the project adds value. In the worked example below, a £1,000 project returning £400, £500 and £600 has an IRR of about 21.7%.
The IRR decision rule
Accept a project if its IRR is higher than the cost of capital (the hurdle rate). Reject it if the IRR is lower. IRR effectively tells you the highest cost of capital the project could bear and still break even.
How to calculate IRR: worked example
A project costs £1,000 and returns £400, £500 and £600 at the end of years 1 to 3. The cost of capital is 10%.
Step 1: NPV at a rate that gives a positive NPV (20%)
| Year | Cash flow (£) | Discount factor at 20% | Present value (£) |
|---|---|---|---|
| 0 | (1,000) | 1.000 | (1,000.00) |
| 1 | 400 | 0.833 | 333.33 |
| 2 | 500 | 0.694 | 347.22 |
| 3 | 600 | 0.579 | 347.22 |
| NPV | 27.78 |
Step 2: NPV at a rate that gives a negative NPV (25%)
| Year | Cash flow (£) | Discount factor at 25% | Present value (£) |
|---|---|---|---|
| 0 | (1,000) | 1.000 | (1,000.00) |
| 1 | 400 | 0.800 | 320.00 |
| 2 | 500 | 0.640 | 320.00 |
| 3 | 600 | 0.512 | 307.20 |
| NPV | (52.80) |
Step 3: Interpolate
IRR = 20% + [27.78 ÷ (27.78 + 52.80)] × (25% − 20%) = 20% + 0.345 × 5% = 21.7%.
The exact figure (from Excel's =IRR) is 21.65%. Interpolation is close enough for exam purposes. Because 21.7% is above the 10% cost of capital, the project is acceptable. Its NPV at 10% is £227.65: see our NPV guide.
IRR in Excel
- =IRR(values): put the cash flows in a row, starting with the negative initial investment, and use =IRR on that range.
- =XIRR(values, dates): use when cash flows arrive on irregular dates.
- =MIRR(values, finance_rate, reinvest_rate): a modified IRR that assumes reinvestment at a realistic rate.
Advantages and limitations of IRR
Advantages
- Easy to understand as a percentage
- Uses all cash flows and the time value of money
- Useful when the cost of capital is uncertain: it shows the maximum it can be
Limitations
- Can mislead when choosing between projects of different size or timing
- Assumes cash is reinvested at the IRR, which may be unrealistic
- Projects with cash flows that change sign more than once can have several IRRs
- Says nothing about the absolute value created
IRR in ACCA SBL
Finance in planning and decision-making is syllabus area G. SBL rarely asks for long calculations, but you may need to interpret an IRR in the case, for example a director claiming a project is attractive because its IRR is 18%. Scepticism marks come from asking what the cost of capital is, whether the cash flow forecasts are realistic, and what the NPV says.
FAQs
What is IRR?
The internal rate of return is the discount rate at which a project's net present value (NPV) is zero. It is the project's own rate of return on the cash invested.
How do you calculate IRR?
Find the NPV at two discount rates, ideally one giving a positive NPV and one a negative NPV, then interpolate: IRR = A + [NPV at A ÷ (NPV at A minus NPV at B)] × (B minus A). In Excel, use =IRR(range) or =XIRR for irregular dates.
What is a good IRR?
Any IRR above the organisation's cost of capital (the return investors require) means the project adds value. How much above depends on the project's risk.
What does a 22% IRR mean?
The project's cash flows earn the equivalent of 22% a year on the money invested. If the cost of capital is, say, 10%, it clears the hurdle comfortably.
What is the difference between IRR and NPV?
NPV gives the value added in money at a set cost of capital. IRR gives a percentage return. When they disagree on mutually exclusive projects, NPV is the better guide because it measures the increase in shareholder wealth.