IRR

What it means

IRR is the discount rate at which a project’s net present value is zero. Put simply: the annual return the project earns once the time value of money is taken into account.

On its own it means nothing. It is compared with the cost of capital: above it the project adds value, below it the money would work harder somewhere else.

IRR carries a hidden assumption that the money a project returns along the way is reinvested at the same rate. With a high IRR that is often unrealistic, so the figure overstates the return. The modified version, MIRR, uses the rate at which the company can actually invest or borrow. Unlike a simple ROI, though, IRR does at least account for when the money arrives.

How it works in practice

In an investment decision it is calculated alongside NPV and payback. IRR communicates easily ("twelve percent a year"), but NPV is what states the gain in euros.

The inputs are cash flows, not profit: the investment, operating receipts and payments, tax, residual value. So it comes from a cash flow model rather than a projected profit and loss account.

In small companies IRR is most often calculated when buying a machine or solar panels, or when comparing a purchase with a lease. We include the tax effect in the flows: tax depreciation costs no cash itself but reduces tax, and tax is a real outflow. Without it the comparison uses numbers that differ from the money in the bank.

What to watch out for

Projects whose flows alternate in sign can have several IRRs or none. Then stick to NPV, or the decision rests on a number that mathematically does not mean what it seems to.

When choosing between two projects, the one with the higher IRR need not win. A small investment with a high percentage can earn fewer euros than a larger one with a lower rate. The value assumed at the end of the period needs the same care: if it is inflated, the IRR looks good only because of one estimate, which ought to have its own justification in the feasibility study.