Internal Rate of Return (IRR): Definition, Formula, How to Calculate?

The Internal Rate of Return (IRR) is a crucial metric for determining the profitability of a project. As a professional with experience in managing numerous projects and holding the PMP (Project Management Professional) certification, I understand the significance of IRR in making informed decisions.

In this article, I will cover the definition, the IRR formula, how to find IRR, and step-by-step calculation of the Internal Rate of Return. I aim to educate aspiring project managers about IRR and project evaluation, drawing from my personal experiences. Whether you're pursuing your PMP certification by taking PMP classes online or improving your project management skills, IRR is crucial for making sound financial decisions in the dynamic world of project management.

When theory meets practice, informed decisions lead to success. Let's explore IRR together.

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What is the Internal Rate of Return (IRR)?

Project managers often use a financial metric called the Internal Rate of Return (IRR) to evaluate the profitability of a project or investment. IRR is calculated as a discount rate that makes the net present value (NPV) of a project's cash flow equal to zero. It is usually expressed as a percentage and helps in determining the potential return on investment over time.

The Internal Rate of Return (IRR) is a useful tool for project managers to evaluate investment options and project proposals. Generally, a higher IRR is desirable as it indicates a better return on investment. However, it is important to consider other financial indicators and qualitative factors in addition to IRR to make informed decisions about project selection and prioritization.

IRR is an important tool for financial analysis and decision-making throughout the project lifecycle.

What Is Internal Rate of Return Used For?

Let me explain how the Internal Rate of Return (IRR) is used in project management with a simple example. As a project manager, you are weighing two project investments and choosing a project based on its prospective returns. To do this, you need to look at each project's five-year cash-flow. Consider Project A and Project B:

• Calculate the IRR for each project to determine which is better.
• The IRR discount rate zeroes all cash flows' Net Present Value (NPV). At this rate of return, future cash inflows match the initial investment's present value.
• Project A has 12% IRR and Project B has 15%. You now compare these rates to your company's cost of capital. If your company's cost of capital is 10%, both projects offer better returns.
• Project B has a greater IRR (15%) than Project A (12%), so you might choose it. If all other things are equal, a larger IRR makes the investment more appealing.
• IRR is only one decision-making aspect; it's commonly used with other financial measures to assess the project's profitability and risk.

Internal Rate of Return (IRR) Formula:

The discount rate at which the Net Present Value (NPV) of a set of cash flows equals zero is called the Internal Rate of Return (IRR). To find the internal rate of return (IRR), you need to compare the cash flows' present value to the starting investment's present value. Here's the formula to find IRR:

Where,

• is the net cash flow during the period ‘t’
• IRR is the Internal Rate of Return
• C0 is the total initial investment cost
• T is the total number of periods

Internal Rate of Return (IRR) Key Points for Project Management

The below-mentioned IRR key points are crucial for any project manager. Project Management online training helps you become proficient in the following key points:

• Project managers evaluate investment profitability using IRR.
• IRR is the discount rate at which cash flow NPV becomes zero.
• IRR compares projects and prioritizes those with higher returns.
• The IRR method of Capital budgeting projects can benefit from using the internal rate of return (IRR) to compare yearly return rates over time.
• Interpreting cash flow patterns can become challenging when there are multiple internal rates of return (IRR) due to their complexity.
• IRR's ultimate aim is to determine the discount rate at which the present value of the sum of yearly nominal cash inflows equals the initial net cash outlay of the investment.

Internal Rate of Return (IRR) Example calculation:

Consider yourself a project manager. To move on, you must review two projects, and then finalize a better IRR project. For example, Project A and B's cash flows are as follows:

Now, let's find the Internal Rate of Return (IRR) for each project using the following

IRR equation:

IRR for Project A:

IRR for project A = 8.9%

IRR for Project B:

IRR for project B = 11.22%

The IRR for Project B is 11.22%, while for Project A it is 8.9%. Therefore, based on the IRR as a measure, Project B is a better choice.

How to Calculate IRR in Excel?

It's easy to figure out the internal rate of return (IRR) in Excel. You can use the built-in IRR function. Here is a step-by-step guide:

1. Set up your data

Create a cash flow table in Excel. Use the first row for labels and the following rows for periods and cash flows. For example:

This example starts with a $1000 investment at time 0, followed by positive cash flows.

2. Use the inbuilt IRR function

Enter the following internal rate of return equation into a cell that is empty and where you want to display the internal rate of return:

fx =IRR(B2:B6)

Here, B2-B6 displays the cash flow ranges and corresponding entries.

3. Press Enter

Once you've finished entering the IRR calculation formula, press Enter. Excel will calculate the IRR using the provided cash amounts.

4. Analyze the Result

The cell with the formula now displays the IRR, which is approximately 25% in this case. This percentage represents the internal rate of return for the cash flow line.

It is important to remember that the Internal Rate of Return (IRR) is the discount rate that results in a Net Present Value (NPV) of zero for your cash flow. In most cases, a project is considered acceptable if the IRR is higher than the required rate of return or the cost of cash.

To make it easier to read, you may want to format the cell displaying the IRR as a percentage in Excel. To do this, right-click on the cell, select "Format Cells," and choose the "Percentage" style.

Ways to Calculate IRR:

A common application of IRR is to compare various investment opportunities. IRR calculation explained in the following ways:

1. IRR Calculation for Uniform Cash Flows

Using the following internal rate of return formula, you can determine the Internal Rate of Return (IRR) for uniform cash flows. For a series of uniform cash flows, the formula simplifies to

Where

• NPV - Net Present Value
• t - Number of years
• Ct - Cash flow in a specific period “t”
• IRR - Internal Rate of Return

The goal is to determine the discount rate (IRR) that makes the net present value (NPV) of the cash flows zero. This problem cannot be solved algebraically for IRR, so project managers often use iterative methods, financial calculators, or software to find the solution.

2. IRR Calculation for Non-uniform Cash Flows

Iterative steps are used to solve IRR for non-uniform cash flows. The NPV formula remains the same, but due to varying cash flows, trial and error or advanced numerical methods may be required.

Iterate manually: To perform an iteration by manual method, follow these steps:

• Start by guessing the rate, for example, 10%.
• Use this rate to calculate the Net Present Value (NPV) by plugging it into the formula.
• Repeat the process by changing the rate and calculating the NPV again until the accuracy is good enough. It's important to keep changing the rate until you achieve the desired level of accuracy.

Calculators or Software tools:

Calculating IRR for non-uniform cash flows can be simple with the help of various financial tools and spreadsheet programs. Microsoft Excel and other similar programs have features like IRR which can assist you in performing the iterative calculation. All you have to do is input the cash flow numbers and let the software do the rest for you.

3. IRR for Mutually Exclusive Projects

The Internal Rate of Return (IRR) is crucial for assessing mutually exclusive projects. When looking at IRRs, the project with a higher rate is a better investment. Incremental analysis, which compares project cash flows, helps make decisions. A comprehensive assessment includes EAC and reinvestment assumptions. Usually, the project with the highest IRR is chosen, providing a straightforward method to select the most profitable of mutually exclusive projects.

Pros and Cons of Internal Rate of Return:

The following are the pros and cons of using Internal Rate of Return (IRR):

Pros:

• IRR establishes a definitive benchmark for decision-making.
• IRR is easy to understand and communicate.
• IRR makes project comparisons easier. This can help you select projects and allocate funds to those with better returns.
• You can utilize IRR to evaluate long-term investment projects in capital planning to allocate resources efficiently.
• Project managers can understand cash flow fluctuations with IRR, which analyzes timing and amount.

Cons:

• IRR assumes project cash flows be reinvested at the same rate as IRR. In volatile markets, this assumption may not apply.
• In some cases, the IRR method formula might be confusing and difficult to calculate.
• IRR is a percentage that non-financial stakeholders may find confusing. Stakeholders may also mistake a greater IRR for success without considering additional variables.
• IRR does not consider the investment size, which may not favor bigger ones.
• IRR may neglect the value and profitability of mutually exclusive projects in favor of higher-return projects.

Limitations of IRR:

IRR has various limitations that should be considered when evaluating projects more thoroughly. Here are the main limitations of the IRR:

• Projects that exhibit unconventional cash flow patterns may have multiple internal rates of return (IRR), which might require further clarification.
• Comparing projects with differing lengths using IRR can be complicated. A short-term project with a high IRR may seem like a good investment, but a lengthy project may have a low IRR, earning profits slowly.
• IRR-based decision-making may be inaccurate if the hurdle rate or capital cost is chosen incorrectly or fluctuates.
• Companies compare IRR when choosing projects. Even with identical IRRs, a company may choose the easier investment if it costs less the initial capital or has less complex factors.
• IRR assumes reinvestment of positive cash flows at the project return rate, but finding eligible reinvestment opportunities at the predicted IRR may take time, resulting in differing returns.

Conclusion

Aspiring project managers and PMP candidates will find that understanding and utilizing IRR can significantly impact project evaluation and decision-making processes. Project managers use IRR to select investments with the best returns. Becoming proficient in IRR requires a deep understanding of a project's potential and financial methods that support project goals.

I highly recommend anyone pursuing KnowledgeHut's PMP training to learn about what does IRR means. It is an incredibly powerful tool that can help you successfully negotiate project finance. By calculating and interpreting IRR, you can make informed decisions that can have a significant impact on the success of your project.

Personally, mastering IRR has helped me improve my project management skills and become a more strategic and successful leader. To all aspiring project managers, I encourage you to embrace the challenges of learning IRR as it can provide you with valuable insights that go beyond financial considerations and transform the way you evaluate and manage projects.