What Is the Internal Rate of Return (IRR) Rule?
The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate.
Key Takeaways
- The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate.
- The IRR Rule helps companies decide whether or not to proceed with a project.
- A company may not rigidly follow the IRR rule if the project has other, less tangible, benefits.
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Understanding the Internal Rate of Return (IRR) Rule
Essentially, the IRR rule is a guideline for deciding whether to proceed with a project or investment. The higher the projected IRR on a project—and the greater the amount it exceeds the cost of capital—the more net cash the project generates for the company. Meaning, in this case, the project looks profitable and management should proceed with it. On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.
Mathematically, IRR is the rate that would result in the net present value (NPV) of future cash flows equaling exactly zero.
Investors and firms use the IRR rule to evaluate projects in capital budgeting, but it may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.
While companies typically follow the conclusions offered by the internal rate of return (IRR) rule, other considerations—such as the size of the project and whether or not the project contributes to a larger strategy or goal of the company—may lead to management deciding to proceed with a project with a low IRR.
Example of the IRR Rule
Assume a company is reviewing two projects. Management must decide whether to move forward with one, both, or neither of the projects. Its cost of capital is 10%, The cash flow patterns for each are as follows:
Project A
- Initial Outlay = $5,000
- Year one = $1,700
- Year two = $1,900
- Year three = $1,600
- Year four = $1,500
- Year five = $700
Project B
- Initial Outlay = $2,000
- Year one = $400
- Year two = $700
- Year three = $500
- Year four = $400
- Year five = $300
The company must calculate the IRR for each project. Initial outlay (period = 0) will be negative. Solving for IRR is an iterative process using the following equation:
$0 = Σ CFt ÷ (1 + IRR)t
where:
- CF = Net Cash flow
- IRR = internal rate of return
- t = period (from 0 to last period)
-or-
$0 = (initial outlay * -1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1 + IRR)X
Using the above examples, the company can calculate IRR for each project as:
IRR Project A:
$0 = (-$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 + IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5
IRR Project A = 16.61 %
IRR Project B:
$0 = (-$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR Project B = 5.23 %
Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B.
Is Using the IRR the Same As Using the Discounted Cash Flow Method?
Yes. Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. The IRR (internal rate of return) is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Investors and firms use IRR to evaluate whether an investment in a project can be justified.
How Is the IRR Rule Used?
Essentially, the IRR rule is a guideline for deciding whether to proceed with a project or investment. So long as the IRR exceeds the cost of capital, the higher the projected IRR on a project, the higher the net cash flows to the company. On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.
Will Firms Always Follow the IRR Rule?
The IRR rule may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR, as long as it still exceeds the cost of capital, because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition. Ultimately, companies consider a number of factors when deciding whether to proceed with a project. There may be factors that outweigh the IRR rule.
