How to calculate an internal rate of return (IRR), and when not to use it

Calculating the internal rate of return (or IRR) of a project is one of the most popular methods that companies and managers use to determine whether a project is worth investing in. Now that I’ve covered a bit about NPVs and DCFs, it makes sense to go through what IRR is, how to use it, and why it’s not an ideal measurement.

When using NPV to determine whether or not to invest in a project, the general rule is to accept the project if NPV > 0 and reject if NPV is negative (or zero).

But since NPV results in a dollar figure, some managers have a hard time conceptualizing what that number (the present value of future cash flows) really represents. Instead, they prefer to look at percentages, and that’s where IRR comes in.

IRR is the rate at which the project NPV equals 0. It also provides the expected return rate of the project, assuming certain conditions are met. In other words, if C(n) is the cash flow for each period, then

and you’d find IRR by setting NPV = 0 and solving for “r” above. (Excel’s IRR function makes this all a cinch by running an iterations.)

Let’s look back at Experiment in Finance’s NPV calculation as an example.

I noted in my previous entry that this site’s NPV through July was $89.93. Here are the cash flows again:

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