What Is the Internal Rate of Return (IRR) Rule?

What Is the Internal Rate of Return (IRR) Rule?

Let me explain the internal rate of return rule directly: it states that you should consider pursuing a project or investment if its IRR is higher than your minimum required rate of return, which we call the hurdle rate. As someone evaluating options, you'll find this rule helpful for deciding on projects or comparing them, but I have to point out its limitations, which I'll cover in this post.

Key Takeaways

Here's what you need to know upfront: the IRR rule means a project could be worthwhile if its IRR beats the hurdle rate. You can use it to choose between projects, but remember, you might not follow it strictly if there are other benefits involved. Also, keep in mind the rule's flaws that could lead to poor decisions.

Understanding the Internal Rate of Return (IRR) Rule

You should think of the IRR rule as a financial checkpoint for projects or investments. It's the rate where the net present value of future cash flows hits zero. If the projected IRR is high and well above your cost of capital, the project will likely generate more net cash, making it worth your time. But if it's below that cost, you're better off skipping it.

In capital budgeting, businesses like yours often apply this rule, though it's not always set in stone. A higher IRR is generally better, but you might pick a lower one if it fits a bigger strategy or blocks competitors. Similarly, you could favor a large project with a modest IRR over a small one with a high rate because of the bigger cash inflows in absolute terms.

Advantages and Disadvantages of the IRR Rule

On the advantages side, the IRR is straightforward for you to calculate and grasp, especially with a spreadsheet, and it lets you compare it against other opportunities. It also factors in the time value of money, meaning it discounts future cash to show that money now is worth more than the same amount later.

However, there are downsides you can't ignore: the IRR overlooks the project's actual dollar scale and any odd cash flow patterns, which could skew your results if applied blindly. Plus, it assumes you reinvest positive cash flows at the same IRR, which isn't realistic— that's why some use the modified IRR, assuming reinvestment at the cost of capital instead.

Example of the IRR Rule

Suppose you're a company manager looking at two projects. Your cost of capital is 10%. Project A starts with a $5,000 outlay, followed by inflows of $1,700, $1,900, $1,600, $1,500, and $700 over five years. Project B has a $2,000 outlay and inflows of $400, $700, $500, $400, and $300.

To find the IRR, you solve for the rate that makes the net present value zero using this equation: 0 = Σ [CFt / (1 + IRR)^t] - C0, where CF is net cash flow, t is the period, and C0 is the initial outlay. It's iterative, so trial and error is key, but spreadsheets make it easier.

Calculating IRR Using a Spreadsheet

Set up your spreadsheet with the outlays as negative in the first row, then list the yearly inflows. Use the =IRR() function on the range—for Project A, it's 17%, and for B, it's 5%. Since 17% beats 10% and 5% doesn't, you'd go with Project A and drop B.

What Is the Downside of the IRR Rule?

One major issue is that it assumes you can reinvest cash flows at the IRR itself, which overstates potential returns. It also fails to handle irregular cash flows, leading to misleading outcomes if those are present.

What Is the Difference Between IRR and ROI?

IRR gives you the annual growth rate, while ROI shows total growth from start to finish. They're similar over a year but diverge longer-term, and ROI is simpler and more common since IRR requires more calculation.

Is Using the IRR Rule the Same as Using the Discounted Cash Flow Method?

Yes, IRR is part of discounted cash flow analysis—it's the discount rate that sets NPV to zero for the cash flow series.

Do Companies Always Follow the IRR Rule?

Not always; you might choose a lower IRR project if it exceeds the cost of capital and offers non-financial perks.

The Bottom Line

Whether you're investing personally or for a business, using capital wisely matters, and the IRR rule helps compare options. But don't rely on it alone—its flaws can mislead you, so consider other factors it misses.