What Is the Internal Rate of Return (IRR) Rule?
The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR exceeds the minimum required rate of return or the hurdle rate. Its root lies in the internal rate of return, which is the return required to break even or net present value (NPV). This rule is an important tool for companies and investors if they want to determine whether to take on a certain project or investment or to compare it to others they may be considering.
Key Takeaways
- The internal rate of return rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return or the hurdle rate.
- The IRR Rule helps companies decide whether or not to proceed with a project.
- A company may not rigidly follow the IRR rule if the project has other, less tangible, benefits.
:max_bytes(150000):strip_icc()/DDM_INV_internal-rate-of-return-rule_final-4x3-4a81608802ef484692bce139ddb8dfcc.jpg "Internal Rate of Return (IRR) Rule: Definition and Example (1)")
Understanding the Internal Rate of Return (IRR) Rule
The IRR rule is essentially a guideline for deciding whether to proceed with a project or investment. Mathematically, IRR is the rate that would result in the net present value of future cash flows equaling exactly zero.
The higher the projected IRR on a project—and the greater the amount it exceeds the cost of capital—the more net cash the project generates for the company. So, if the project looks profitable, management should proceed with it. On the other hand, if the IRR is lower than the cost of capital, the rule suggests that the best course of action is to forego the project or investment.
Investors and firms use the IRR rule to evaluate projects in capital budgeting. But it may not always be rigidly enforced. Generally, the higher the IRR, the better. However, 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 rate because of the higher cash flows generated by the larger project.
Advantages and Disadvantages of the IRR Rule
Advantages
Anyone who uses the internal rate of return rule often finds it easy to determine and understand. Companies and investors can easily calculate it and compare it to other projects and investments that are under consideration.
Another advantage of using this rule is that it helps companies and investors consider the time value of money (TVM). This is a concept that states that an amount of money will be worth more now than the same sum in the future. As such, the future cash flow that results from an investment is discounted to its present value under the IRR rule.
Disadvantages
The IRR rule doesn't take the actual dollar value of the project or any anomalies in cash flows into account. If there are any irregular or uncommon forms of cash flow, the rule shouldn't be applied. If it is, it may result in flawed findings.
Another key disadvantage of the IRR rule is that it is flawed in its assumption of any reinvestments made from positive cash flow—notably, that they are made at the same internal rate of return.
Pros
Easy to calculate and understand
Allows for comparison between other projects and investments
Takes time value of money into account
Cons
Doesn't account for actual dollar value
Doesn't consider anomalies in cash flows
Assumes that reinvestments are made at the same internal rate of return
Example of the IRR Rule
Let's assume that a company is reviewing two projects in which to invest its money. Management must decide whether to move forward with one, both, or neither of the projects. Its cost of capital is 10%. The cash flow patterns for each project are highlighted in the following table:
| Project A | Project B | |
| Initial Outlay | $5,000 | $2,000 |
| Year One | $1,700 | $400 |
| Year Two | $1,900 | $700 |
| Year Three | $1,600 | $500 |
| Year Four | $1,500 | $400 |
| Year Five | $700 | $300 |
The company must calculate the IRR for each project. The initial outlay (period = 0) will be negative. Solving for IRR is an iterative process (where results for each period are summed) using the following equation. The upper case sigma (Σ) denotes summation, or creating terms for each period using the formula that follows the symbol and then adding the result for each period:
$0 = Σ [ CFt ÷ (1 + IRR)t ] - C0
Where:
- CF = Net Cash flow
- IRR = Internal rate of return
- t = Period (from 0 to last period)
- C0 = The initial outlay
The formula looks like this with the terms in order. The initial outlay is multiplied by -1 because it is money being subtracted from the project:
$0 = [ initial outlay * -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. In each term, "IRR" must be substituted with an educated guess because the only way to determine the best IRR is through trial and error:
- 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
You can see how this can become manually tedious and prone to errors.
IRR using a Spreadsheet
Using these same values in a spreadsheet, you can use this function:
=IRR(x:y)
Where:
- X is the first cell in a column
- Y is the last cell in the same column
- The initial outlay should be negative
The following table shows the entries and the function.
| A | B | ||
|---|---|---|---|
| 1 | Initial Outlay | -$5,000 | -$2,000 |
| 2 | Year One | $1,700 | $400 |
| 3 | Year Two | $1,900 | $700 |
| 4 | Year Three | $1,600 | $500 |
| 5 | Year Four | $1,500 | $400 |
| 6 | Year Five | $700 | $300 |
| 7 | Results | =IRR(A1:A6) | =IRR(B1:B6) |
In the spreadsheet, enter the following in one cell:
=IRR(A1:A6)
And in another cell, enter:
=IRR(B1:B6)
In the spreadsheet, project A results in an IRR of 17%, and project B results in an IRR of 5%. Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B because the internal rate of return is higher than the project's cost.
Is Using the IRR Rule the Same As Using the Discounted Cash Flow Method?
Yes, using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. The internal rate of return is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value of zero or to the current value of cash invested. Investors and firms use IRR to evaluate whether an investment in a project can be justified.
How Is the IRR Rule Used?
The IRR rule is used as a guideline for deciding whether to proceed with a project or investment. The higher the projected IRR on a project, the higher the net cash flows to the company as long as the IRR exceeds the cost of capital. In this case, a company would be well off to proceed with the project or investment. But 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.
Do Firms Always Follow the IRR Rule?
The IRR rule may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR as long as it still exceeds the cost of capital. That's because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition. Companies ultimately consider several factors when deciding whether to proceed with a project. There may be factors that outweigh the IRR rule.
The Bottom Line
It's important to weigh all your options and determine if a project or investment is worth the risk or reward. This applies whether you're an individual investor or if you run a company. One way to ascertain this is to follow the internal rate of return rule. This rule states that you should only take on a new venture if its IRR exceeds the breakeven point. If it's lower, you may want to reconsider whether it's worth the investment.
