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%.*

Year | Cash 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*

Input | Keystroke | Output |

-800,000 | CF 0 | |

275,000 | CF 1 | |

400,000 | CF 2 | |

500,000 | CF 3 | |

400,000 | CF 4 | |

IRR | 31.09 |

*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:

- Independent projects whose IRR is greater than the WACC should always be accepted.
- 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