How it works
IRR is a single percentage that summarises an investment's cash flows over time. You compare it with the return you require. If the IRR is above your required return, the investment looks attractive on that measure.
IRR has weaknesses. It does not show the size of the profit. It can give more than one answer when cash flows change sign several times. And it assumes cash flows can be reinvested at the IRR itself. So analysts pair IRR with MOIC and NPV.
NPV = Sum of [Cash flow in year t ÷ (1 + IRR)^t] = 0
A simple example
How it is used
- Judging private equity, property and project investments.
- Comparing projects against a required return.
- Reporting fund performance.
Common mistakes
- Comparing the IRRs of very differently sized projects without looking at NPV.
- Ignoring the timing assumptions.
- Quoting IRR without the money multiple.
- Using IRR when cash flows alternate between positive and negative.
Questions
What is a good IRR?
It must beat the return you require for the risk taken. Private equity funds often target around 20% a year or more. Infrastructure investors accept lower rates for lower risk.
What is the difference between IRR and ROI?
ROI measures total return and ignores time. IRR is an annualised return that accounts for timing.
Keep learning
- What is NPV (net present value)?
- What is a DCF (discounted cash flow)?
- What is WACC (weighted average cost of capital)?
- Guide: Leveraged buyouts (LBO)
- Guide: Project finance
- Glossary: Internal rate of return (IRR)
- Glossary: Multiple on invested capital (MOIC)
- Glossary: Net present value (NPV)
- Glossary: Discount rate