Calculate the internal rate of return (IRR) for investments. Find the discount rate that makes the net present value of all cash flows equal to zero.
IRR exceeds the hurdle rate — this investment meets return requirements.
NPV at different discount rates (IRR is where NPV = 0)
Internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. In other words, it's the annualized rate of return an investment is expected to generate over its lifetime. IRR is one of the most widely used metrics in capital budgeting and investment analysis.
The concept is powerful because it distills a complex series of cash flows into a single percentage that can be easily compared against a required rate of return or alternative investments. When evaluating whether to proceed with a project, you compare the IRR to your hurdle rate (minimum acceptable return).
The IRR is found by solving this equation for the rate (r) that makes NPV equal zero:
Where:
There's no algebraic solution for IRR — it must be calculated iteratively using numerical methods like Newton-Raphson or trial and error.
Consider a $100,000 investment with the following cash flows:
| Year | Cash flow |
|---|---|
| 0 | -$100,000 |
| 1 | $25,000 |
| 2 | $30,000 |
| 3 | $35,000 |
| 4 | $40,000 |
| 5 | $45,000 |
The IRR for this investment is approximately 16.8%. This means if you discount all cash flows at 16.8%, the NPV would be exactly zero.
| IRR vs hurdle rate | Interpretation | Decision |
|---|---|---|
| IRR > Hurdle rate | Exceeds minimum return | Accept project |
| IRR = Hurdle rate | Meets minimum return | Indifferent |
| IRR < Hurdle rate | Below minimum return | Reject project |
The hurdle rate is typically the company's weighted average cost of capital (WACC) or the investor's required rate of return. For venture capital investments, hurdle rates of 20-30% are common due to the high risk involved.
| Investment type | Typical target IRR |
|---|---|
| Government bonds | 3-5% |
| Corporate bonds | 5-8% |
| Real estate | 10-15% |
| Private equity | 15-25% |
| Venture capital | 25-35%+ |
| Early-stage startups | 40%+ |
Both metrics are valuable but serve different purposes:
A common best practice is to use both metrics together. If they give conflicting signals, NPV is generally preferred.
Traditional IRR assumes interim cash flows are reinvested at the IRR itself, which may be unrealistic for high-return projects. MIRR addresses this by:
MIRR typically gives more conservative (lower) results than IRR and is considered more realistic.
When cash flows change signs more than once (positive, then negative, then positive again), multiple mathematical solutions exist. For example, a project requiring additional investment partway through can have two or more valid IRRs.
IRR assumes all intermediate cash flows can be reinvested at the IRR rate. For a project with 40% IRR, this assumption may be unrealistic.
IRR doesn't account for project size. A 50% return on $10,000 is less valuable than a 20% return on $1,000,000 in absolute terms.
Two projects with identical IRRs but different cash flow timing may have very different NPVs, especially in varying interest rate environments.
Companies use IRR to evaluate:
IRR is the standard metric for measuring fund performance and individual deal returns.
Property investors calculate IRR including purchase price, rental income, operating expenses, and eventual sale proceeds.
When capital is limited, IRR helps rank projects by their efficiency in generating returns.