internal rate of return
Internal rate of return is the percentage return an investment is expected to generate annually over its lifetime, based on future cash flows.
Why internal rate of return helps you compare investments
Internal rate of return measures the annualized return a project is expected to deliver over time. It’s the discount rate that makes the net present value of future cash flows equal zero. In plain terms, it tells you the break-even point where benefits match costs.
This metric is widely used in capital budgeting. It helps companies compare projects of different sizes, durations, or structures. If a project’s return exceeds your required minimum—known as the hurdle rate—it’s usually a green light. If it falls short, think twice. That’s why IRR works best when paired with strong judgment and clear benchmarks.
It’s especially useful when you want to speak in percentages rather than dollar values. A 17% return sounds more intuitive than “$1.3 million in positive NPV.” But behind that percentage lies the same analysis. The value comes from understanding how future returns behave relative to investment size and timing.
A real-world example of IRR in project selection
Say you’re evaluating two potential investments. Project A requires $1 million upfront and generates $300,000 per year for five years. Project B needs $500,000 and pays $160,000 per year. On paper, they look similar. But once you calculate each project’s internal rate of return, A gives 18%, and B gives 21%.
Now you’re not just looking at totals. You’re comparing efficiency. That difference might shift your decision—especially if capital is limited or time to value is strategic. In a portfolio context, IRR becomes your sorting tool. I’ve worked with leadership teams who used it to navigate multiple competing initiatives. When priorities got messy, this metric cut through the noise.
It also forces a conversation about assumptions. If your projected cash flows are optimistic or the investment timeline drags, your IRR will collapse. That’s a good thing—it keeps reality in the equation.
What internal rate of return doesn’t tell you
This is not a perfect tool. For starters, it assumes you can reinvest interim cash flows at the same return, which rarely holds true. It also doesn’t account for project scale. A small investment might show a higher return but deliver less overall value than a larger, lower-yielding one.
Another limitation is ambiguity. Some projects generate multiple IRRs depending on cash flow timing. When that happens, interpretation gets murky. You need to use this metric alongside others like net present value or payback period to build a complete picture.
Let it guide—but not dominate—your decisions
Internal rate of return is a sharp tool. Use it to compare, filter, and challenge assumptions—but never in isolation. Context always wins.
« Back to Glossary Index