Internal Rate of Return in Project Management: IRR Formula & Examples

The full definition of the internal rate of return is as follows: IRR finds a discount rate that is needed for the sum of all present values of future cashflows to result in 0.

Here’s a brief explanation of terms related to IRR:

IRR is a frequently used in capital budgeting, to compare the viability of different projects. It’s mostly used by finance teams and project analysts to make reliable investment decisions. In essence, it provides you with an annualized growth indicator that helps determine if your investment will meet required returns.

Here’s how we put this into a formula:

To calculate IRR, you’ll need to have:

Here’s an example for a time period of 2 years, cashflows of $8,000, and three different suggested discount rates:

We see that 5% and 20% are not the correct IRR, since the NPV (or the sum of the current value of future streams) is not 0.

So, the accurate IRR is 38%, since the sum of cashflows for year 1 and 2 amounts to $9,999, which is approximately equal to the initial investment of $10,000.

If you don’t know how to get the present value of future cashflows, you’ll be in a bind when trying to figure out IRR. Here’s how you can calculate this metric:

You’ll need to:

So, let’s say you will receive $8,000 in one year and the discount rate is 37.98%:

Step One: Add 1 to the discount rate → Since the rate is 37.98%, this means 1.3798

Step Two: Divide the future cash flow by this number → $8,000 ÷ 1.3798

Step Three: The result is the present value → About $5,797.94

Although it’s a fairly simple calculation, here’s an example of investments with different initial costs and varying cash inflows:

As you can see, the project with the highest return also has the highest IRR, which is usually the case. Despite this, IRR shouldn’t be used as the sole indicator for capital budgeting decisions, even if data points to the fact that it often is.

IRR doesn’t take into account the fact that it can sometimes be more beneficial to go with a larger project with a smaller IRR, than a very small project with a larger IRR.

In these examples, going for Project 1 instead of Project 2 may seem logical, but it’s not necessarily the correct choice for the business.

Applying an absolute value to IRR is hard, since the benefit of different investment options varies depending on different internal factors, such as risk tolerance, capital availability, investment horizon, industry conditions, and strategic business goals.

In theory, a bigger IRR is better than a smaller one. Why is this? Because it allows for more leeway between the cost of capital and the calculated IRR.

The basic criteria for going with a project is that IRR > cost of capital. So, the bigger the difference between the cost of capital and IRR, the bigger your return on investment.

However, like we’ve discussed in the previous example, IRR is just one of the financial metrics you should take into account. Net present value is often used alongside it, to provide further context to your financial decisions.

While IRR is a powerful tool for evaluating investment profitability, it has limitations that NPV helps address.

Like we’ve previously mentioned, it’s a financial metric that measures the total value an investment generates by discounting future cash flows to their present value. A positive NPV indicates profitability, while a negative NPV suggests a loss.

Here’s a step-by-step explainer on how to calculate NPV:

Here’s an example with a discount rate of 10%:

The final calculation is NPV = $10,000 – ($4545.45 + $5785.12) = $330.57.

IRR and NPV together provide a more comprehensive assessment of investment decisions. These financial metrics should be seen as complementary, rather than at odds with each other.

Here’s how calculating both metrics benefits your financial analysis:

IRR can sometimes produce multiple values when a project has alternating cash inflows and outflows (negative cash flows, then positive cash flows, then negative), making decision-making confusing. NPV avoids this issue by providing a clear monetary value of the investment’s profitability.

IRR only shows the percentage return but doesn’t consider the absolute size of an investment. A small project with a high IRR might generate less profit than a large project with a lower IRR. NPV accounts for total value creation, helping decision-makers focus on potential investments that generate the highest overall wealth.

IRR does not explicitly compare an investment to the required rate of return. NPV, on the other hand, directly incorporates the company’s cost of capital, showing the real dollar value added to the firm. A project with a positive NPV ensures that the return exceeds financing costs, making it a better metric for decision-making.

IRR assumes that future cash flows are reinvested at the IRR itself, which can be unrealistic. In fact, research by McKinsey shows just how unrealistic and flawed the reinvestment-rate assumption can be:

Source: Justin C. Keheller and Justin J. MacCormack

NPV assumes reinvestment at the discount rate, which is typically more reasonable and aligns with real-world financing conditions.

IRR and payback period analysis are both methods of calculating rates of return.The difference is that IRR:

In comparison, payback period analysis is a simple calculation which gives finance professionals the period of time within which potential projects will recoup costs. However, it doesn’t take into account the time value of money and ignores cash flows after the break-even point.

Payback period is often recommended to be used as a preliminary step in cash flow analysis. You start by measuring the payback period on different projects, then decide on the actual investment to undertake based on the results of NPV and IRR anaysis.

Here are the main reasons why IRR perseveres as a popular metric, despite its already mentioned flaws:

Here’s a quick overview of the main limitations of IRR:

Many of these faults can be improved by making financial decisions on the basis of multiple indicators, and not just one.

IRR is a valuable tool in project management, though it shouldn’t be your only metric for decision-making. While it effectively measures potential returns and helps compare ROI, you’ll need to evaluate it alongside NPV, payback period, and other financial indicators.

By understanding IRR’s strengths and limitations, you can make more informed investment decisions that align with your organization’s strategic objectives.

If you’re looking for tools and software to help you make informed decisions, consider using project management software like Productive.

With Productive, you can manage project budgets in real time, forecast profitability, and compare different financial scenarios to adjust your strategic planning. Book a demo to learn more.

The cost of capital is the required return a company must earn on its investments to cover financing costs. It represents the minimum rate of return needed to justify an investment. The cost of capital includes debt costs (interest on loans) and equity costs (expected shareholder returns). 

A hurdle rate is the minimum acceptable rate of return a company sets when evaluating investment projects. It is typically equal to or higher than the cost of capital and serves as a benchmark. If a project’s IRR exceeds the hurdle rate, it is considered viable. 

A cost-benefit analysis (CBA) is a decision-making process that compares the total expected costs of a project to its total expected benefits. The goal is to determine whether the benefits outweigh the costs and justify the investment. 

The Rate of Return (RoR) is a broad measure of investment profitability, calculated as the gain or loss relative to the initial investment. Internal Rate of Return (IRR) is a specific type of RoR that finds the discount rate where Net Present Value (NPV) equals zero. Unlike a simple RoR, IRR accounts for the time value of money, making it more useful for long-term evaluations.