Internal rate of profitability (IRR): Definition and example

The Internal Rate of Return (IRR) is a fundamental tool in the world of finance, used to evaluate the viability and profitability of investment projects. It is an essential metric for investors, companies and finance professionals, as it provides critical insight into the profitability of a project over time. In this article, we will explore in detail what IRR is, what it is for, what its calculation formula is like and how we can calculate it easily using Microsoft Excel/Spreadsheets.

What is the internal rate of profitability (IRR)?

The internal rate of profitability (IRR) is a metric used in financial analysis to estimate the profitability of possible investments. The IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. The IRR calculations are based on the same formula as the NPV. It must be taken into account that the IRR is not the real dollar value of the project. It is the annual profitability that makes the NPV equal to zero. In general terms, the higher the internal rate of return, the more desirable it is to undertake an investment. The IRR is uniform for investments of different types and, as such, can be used to classify multiple potential investments or projects on a relatively uniform basis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR would likely be considered the best.

bar graph

Development of a company's IRR. Source: Corporate Finance Institute.

What is the IRR for?

The ultimate goal of the IRR is to identify the discount rate that makes the present value of the sum of nominal annual cash inflows equal to the initial net investment outlay. Various methods can be used when seeking to identify an expected profitability, but the IRR is often ideal for analyzing the potential profitability of a new project that a company is considering undertaking. It should be noted that the IRR is the growth rate that an investment is expected to generate annually. Therefore, it can be very similar to a compound annual growth rate (CAGR). In reality, an investment does not usually have the same rate of return each year. Generally, the actual rate of return that a given investment ends up generating will differ from its estimated IRR.

How to calculate the IRR

We have different ways to calculate the IRR, which range from:

  • Using the formula, we set the NPV to be equal to zero and it would be solved for the discount rate, which is the IRR.
  • The initial investment is always negative because it represents an outflow.
  • Each subsequent cash flow could be positive or negative, depending on estimates of what the project will provide or require as a capital injection in the future.
  • Due to the nature of the formula, the IRR cannot be easily calculated analytically and instead must be calculated iteratively through trial and error or using software programmed to calculate the IRR (for example, using Excel).
formula

IRR calculation formula. Source: Sage.

Calculate the IRR in Excel

All you have to do is combine the cash flows, including the initial outlay and subsequent inflows, with the IRR function. The IRR function is found by clicking the Insert Formulas (fx) icon. Below you have a simple example of IRR analysis with known and periodic cash flows annually (one year apart). Suppose a company is evaluating the profitability of Project In this case, the IRR is 250.000%, which is quite high.

table

Example of calculating the IRR of an investment.


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