Internal Rate of Return

The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows.

Let’s look at an example:

Blue Ocean is evaluating a proposed capital budgeting project (project Vulcan) that will require an initial investment of $800,000.

Blue Ocean has been basing capital budgeting decisions on the project’s NPV but recently they acquired a new CEO who wants the finance team to use IRR method for capital budgeting decisions. The new CEO explains that the IRR is a better method because it shows returns in percentage form and are easier to understand and compare to required returns. Blue Ocean’s WACC is 7%.

YearCash Flow
Year 1$275,000
Year 2$400,000
Year 3$500,000
Year 4$400,000

The IRR is solved by setting the NPV equation equal to zero and solving for the interest rate as follows:

Financial Calculator

InputKeystrokeOutput
-800,000CF 0
275,000CF 1
400,000CF 2
500,000CF 3
400,000CF 4
IRR31.09

Excel

=IRR(-800000,275000,400000,500000,400000,[guess])

We found that Vulcan’s IRR 31.09%. But what does that exactly mean?

It means the project has an NPV of $0 because the IRR is greater than Blue Ocean’s WACC of 7%. The returns from the project (IRR) exceed the WACC and the excess value will go to shareholders.

In summary, the two rules you should note are:

  1. Independent projects whose IRR is greater than the WACC should always be accepted.
  2. If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the firm should accept the project with the greatest IRR