Internal rate of return

The internal rate of return (IRR) or economic rate of

return (ERR) is a rate of return used in capital budgeting
to measure and compare the protability of investments.
It is also called the discounted cash ow rate of return
(DCFROR).[1] In the context of savings and loans the
IRR is also called the eective interest rate. The term
internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or
ination).

rate of return is greater than an established minimum

acceptable rate of return or cost of capital. In a scenario where an investment is considered by a rm that
has shareholders, this minimum rate is the cost of capital
of the investment (which may be determined by the riskadjusted cost of capital of alternative investments). This
ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds
its cost of capital adds value for the company (i.e., it is
economically protable).
One of the uses of IRR is by corporations that wish to
compare capital projects. For example, a corporation will
evaluate an investment in a new plant versus an extension
of an existing plant based on the IRR of each project.
In such a case, each new capital project must produce
an IRR that is higher than the companys cost of capital.
Once this hurdle is surpassed, the project with the highest
IRR would be the wiser investment, all other things being
equal (including risk).

Denition

The internal rate of return on an investment or project

is the annualized eective compounded return rate or
rate of return that makes the net present value (NPV as
NET*1/(1+IRR)^year) of all cash ows (both positive
and negative) from a particular investment equal to zero.
It can also be dened as the discount rate at which the
present value of all future cash ow is equal to the initial IRR is also useful for corporations in evaluating stock
investment or in other words the rate at which an invest- buyback programs. Clearly, if a company allocates a
ment breaks even.
substantial amount to a stock buyback, the analysis must
In more specic terms, the IRR of an investment is the show that the companys own stock is a better investment
discount rate at which the net present value of costs (neg- (has a higher IRR) than any other use of the funds for
ative cash ows) of the investment equals the net present other capital projects, or than any acquisition candidate
value of the benets (positive cash ows) of the invest- at current market prices.
ment.
IRR calculations are commonly used to evaluate the
desirability of investments or projects. The higher a 3 Calculation
projects IRR, the more desirable it is to undertake the
project. Assuming all projects require the same amount Given a collection of pairs (time, cash ow) involved in
of up-front investment, the project with the highest IRR a project, the internal rate of return follows from the net
would be considered the best and undertaken rst.
present value as a function of the rate of return. A rate of
A rm (or individual) should, in theory, undertake all return for which this function is zero is an internal rate of
projects or investments available with IRRs that exceed return.
the cost of capital. Investment may be limited by avail- Given the (period, cash ow) pairs ( n , Cn ) where n is a
ability of funds to the rm and/or by the rms capacity positive integer, the total number of periods N , and the
or ability to manage numerous projects.
net present value NPV , the internal rate of return is given
by r in:

Uses of IRR
NPV =

Because the internal rate of return is a rate quantity, it is

an indicator of the eciency, quality, or yield of an investment. This is in contrast with the net present value,
which is an indicator of the value or magnitude of an investment.

Cn
=0
(1
+
r)n
n=0

The period is usually given in years, but the calculation

may be made simpler if r is calculated using the period
in which the majority of the problem is dened (e.g., using months if most of the cash ows occur at monthly
An investment is considered acceptable if its internal intervals) and converted to a yearly period thereafter.
1

3 CALCULATION

Any xed time can be used in place of the present (e.g., 3.1.2 Numerical solution for single outow and
the end of one interval of an annuity); the value obtained
multiple inows
is zero if and only if the NPV is zero.
Of particular interest is the case where the stream of payIn the case that the cash ows are random variables, such
ments consists of a single outow, followed by multiple
as in the case of a life annuity, the expected values are put
inows occurring at equal periods. In the above notation,
into the above formula.
this corresponds to:
Often, the value of r cannot be found analytically. In this
case, numerical methods or graphical methods must be
used.
C0 < 0, Cn 0 for n 1.

3.1

In this case the NPV of the payment stream is a convex,

strictly decreasing function of interest rate. There is always a single unique solution for IRR.

Example

If an investment may be given by the sequence of cash Given two estimates r1 and r2 for IRR, the secant method
equation (see above) with n = 2 always produces an imows
proved estimate r3 . This is sometimes referred to as the
then the IRR r is given by
Hit and Trial (or Trial and Error) method. More accurate
interpolation formulas can also be obtained: for instance
the secant formula with correction
36200
54800
48100
NPV = 123400+
+
+
= 0.
(1 + r)1 (1 + r)2 (1 + r)3
(
)(
rn rn1
NPVn1
r
=
r
NPV
1 1.4
n
n
In this case, the answer is 5.96% (in the calculation, that n+1
NPVn NPVn1
NPVn1 3NPVn +
is, r = .0596).
(which is most accurate when 0 > NPVn > NPVn1
) has been shown to be almost 10 times more accurate
than the secant formula for a wide range of interest rates
3.1.1 Numerical solution
and initial guesses. For example, using the stream of
Since the above is a manifestation of the general problem payments {4000, 1200, 1410, 1875, 1050} and initial
of nding the roots of the equation NPV(r) = 0 , there guesses r1 = 0.25 and r2 = 0.2 the secant formula with
are many numerical methods that can be used to estimate correction gives an IRR estimate of 14.2% (0.7% error)
as compared to IRR = 13.2% (7% error) from the secant
r . For example, using the secant method, r is given by
method. Other improved formulas may be found in [2]
(
rn+1 = rn NPVn

rn rn1
NPVn NPVn1

)
.

where rn is considered the n th approximation of the IRR.

This r can be found to an arbitrary degree of accuracy.
An accuracy of 0.00001% is provided by Microsoft Excel.

If applied iteratively, either the secant method or the improved formula always converges to the correct solution.
Both the secant method and the improved formula rely on
initial guesses for IRR. The following initial guesses may
be used:

r1 = (A/|C0 |)

2/(N +1)

The convergence behaviour of by the following:

If the function NPV(i) has a single real root r , then
the sequence converges reproducibly towards r .
If the function NPV(i) has n real roots r1 ,r2 ,...,rn ,
then the sequence converges to one of the roots, and
changing the values of the initial pairs may change
the root to which it converges.
If function NPV(i) has no real roots, then the sequence tends towards +.

r2 = (1 + r1 )p 1
where

A = inows of sum = C1 + + CN

p=

log(A/|C0 |)
.
log(A/NPV1,in )

Having r1 >r0 when NPV0 > 0 or r1 <r0 when NPV0 < 0 Here, NPV1,in refers to the NPV of the inows only (that
is, set C0 = 0 and compute NPV).
may speed up convergence of rn to r .

3.2

Decision criterion

In a series of cash ows like (10, 21, 11), one initially invests money, so a high rate of return is best, but
If the IRR is greater than the cost of capital, accept the then receives more than one possesses, so then one owes
project.
money, so now a low rate of return is best. In this case
If the IRR is less than the cost of capital, reject the it is not even clear whether a high or a low IRR is better. There may even be multiple IRRs for a single project,
project.
like in the example 0% as well as 10%. Examples of this
type of project are strip mines and nuclear power plants,
where there is usually a large cash outow at the end of
4 Problems with using internal the project.

rate of return

In general, the IRR can be calculated by solving a polynomial equation. Sturms theorem can be used to determine
As an investment decision tool, the calculated IRR should if that equation has a unique real solution. In general the
not be used to rate mutually exclusive projects, but only IRR equation cannot be solved analytically but only iteratively.
to decide whether a single project is worth investing in.
When a project has multiple IRRs it may be more convenient to compute the IRR of the project with the benets
reinvested.[3] Accordingly, MIRR is used, which has an
assumed reinvestment rate, usually equal to the projects
cost of capital.
It has been shown[4] that with multiple internal rates of
return, the IRR approach can still be interpreted in a way
that is consistent with the present value approach provided that the underlying investment stream is correctly
identied as net investment or net borrowing.
See also [5] for a way of identifying the relevant value of
the IRR from a set of multiple IRR solutions.

NPV vs discount rate comparison for two mutually exclusive

projects. Project 'A' has a higher NPV (for certain discount rates),
even though its IRR (= x-axis intercept) is lower than for project
'B' (click to enlarge)

In cases where one project has a higher initial investment

than a second mutually exclusive project, the rst project
may have a lower IRR (expected return), but a higher
NPV (increase in shareholders wealth) and should thus
be accepted over the second project (assuming no capital
constraints).

Despite a strong academic preference for NPV, surveys

indicate that executives prefer IRR over NPV.[6] Apparently, managers nd it easier to compare investments of
dierent sizes in terms of percentage rates of return than
by dollars of NPV. However, NPV remains the more accurate reection of value to the business. IRR, as a measure of investment eciency may give better insights in
capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate
measure.

IRR should not be used to compare projects of dierent duration. For example, the net present value added
by a project with longer duration but lower IRR could be
greater than that of a project of similar size, in terms of
total net cash ows, but with shorter duration and higher
IRR.

5 Mathematics

In the case of positive cash ows followed by negative

ones and then by positive ones (for example, + + +)
the IRR may have multiple values. In this case a discount
rate may be used for the borrowing cash ow and the IRR
calculated for the investment cash ow. This applies for
example when a customer makes a deposit before a specic machine is built.

Thus, internal rate(s) of return follow from the net present

value as a function of the rate of return. This function is
continuous. Towards a rate of return of 100% the net
present value approaches innity with the sign of the last
cash ow, and towards a rate of return of positive innity
the net present value approaches the rst cash ow (the
one at the present). Therefore, if the rst and last cash

Mathematically, the value of the investment is assumed to

undergo exponential growth or decay according to some
rate of return (any value greater than 100%), with discontinuities for cash ows, and the IRR of a series of cash
Modied Internal Rate of Return (MIRR) considers cost ows is dened as any rate of return that results in a net
of capital, and is intended to provide a better indication present value of zero (or equivalently, a rate of return that
of a projects probable return.
results in the correct value of zero after the last cash ow).

4
ow have a dierent sign there exists an internal rate of
return. Examples of time series without an IRR:

9 SEE ALSO

7 The internal rate of return in

personal nance

The IRR can be used to measure the money-weighted

Only negative cash ows the NPV is negative for
performance of nancial investments such as an individevery rate of return.
ual investors 401(k) or brokerage account. For this scenario, an equivalent,[9] more intuitive denition of the
IRR is, The IRR is the annual interest rate of the xed
(1, 1, 1), rather small positive cash ow between
rate account (like a somewhat idealized savings account)
two negative cash ows; the NPV is a quadratic
which, when subjected to the same deposits and withfunction of 1/(1 + r), where r is the rate of return, or
drawals as the actual investment, has the same ending balput dierently, a quadratic function of the discount
ance as the actual investment. This xed rate account is
rate r/(1 + r); the highest NPV is 0.75, for r =
also called the replicating xed rate account for the invest100%.
ment. There are examples where the replicating xed rate
account encounters negative balances despite the fact that
the actual investment did not.[9] In those cases, the IRR
In the case of a series of exclusively negative cash ows calculation assumes that the same interest rate that is paid
followed by a series of exclusively positive ones, the re- on positive balances is charged on negative balances. It
sulting function of the rate of return is continuous and has been shown that this way of charging interest is the
monotonically decreasing from positive innity (when the root cause of the IRRs multiple solutions problem.[10][11]
rate of return approaches 100%) to the value of the rst If the model is modied so that, as is the case in real life,
cash ow (when the rate of return approaches innity), so an externally supplied cost of borrowing (possibly varythere is a unique rate of return for which it is zero. Hence, ing over time) is charged on negative balances, the multithe IRR is also unique (and equal). Although the NPV- ple solutions issue disappears.[10][11] The resulting rate is
function itself is not necessarily monotonically decreasing called the xed rate equivalent (FREQ).[9]
on its whole domain, it is at the IRR.
Similarly, in the case of a series of exclusively positive
cash ows followed by a series of exclusively negative
ones the IRR is also unique.

8 Unannualized internal rate of return

Finally, by Descartes rule of signs, the number of internal rates of return can never be more than the number of
In the context of investment performance measurement,
changes in sign of cash ow.
there is sometimes ambiguity in terminology between the
periodic rate of return, such as the internal rate of return
as dened above, and a holding period return. The term
internal rate of return or IRR or Since Inception Internal
6 The reinvestment misconception Rate of Return (SI-IRR) is in some contexts used to refer
to the unannualized return over the period, particularly
for periods of less than a year.[12]
It is often stated that IRR assumes reinvestment of all cash
ows until the very end of the project. This is a misconception. There is no hidden reinvestment assumption
associated with the calculation of IRR. IRR is simply the 9 See also
solution to the equation in the example shown above. The
cash ows are static. The NPV is set at zero. There is only
Accounting rate of return
one unknown variable in the equation, namely r.
Capital budgeting
This misconception likely stems from the modied internal rate of return MIRR concept, which allows for inclu Discounted cash ow
sion of a second, subsequent investment. If the reinvestment rate is set at IRR, the MIRR equals the IRR. This
Modied internal rate of return
is hardly a surprise - compounding cash ows (with the
Modied Dietz method
IRR) and then discounting them using the same discount
factor (the IRR) is obviously a zero-sum game.
Net present value
There are many, highly reputable sources [3][7] arguing
that there is a hidden reinvestment assumption in the IRR
Rate of return
calculation. There are, however, also many sources dis Simple Dietz method
puting the so-called reinvestment assumption.[8]

10

References

[1] Project Economics and Decision Analysis, Volume I: Deterministic Models, M.A.Main, Page 269
[2] Moten, J. and Thron, C., Improvements on Secant
Method for Estimating Internal Rate of Return, International Journal of Applied Mathematics and Statistics 42:12(2013), http://www.ceser.in/ceserp/index.php/
ijamas/article/view/1929.
[3] Internal Rate of Return: A Cautionary Tale
[4] Hazen, G. B., A new perspective on multiple internal
rates of return, The Engineering Economist 48(2), 2003,
3151.
[5] Hartman, J. C., and Schafrick, I. C., The relevant internal
rate of return, The Engineering Economist 49(2), 2004,
139158.
[6] Pogue, M.(2004). Investment Appraisal: A New Approach. Managerial Auditing Journal.Vol. 19 No. 4,
2004. pp. 565570
[7] Measuring Investment Returns
[8]
[9] The Mathematics of the Fixed Rate Equivalent, a
GreaterThanZero White Paper.
[10] Teichroew, D., Robicheck, A., and Montalbano, M.,
Mathematical analysis of rates of return under certainty,
Management Science Vol. 11 Nr. 3, January 1965, 395
403.
[11] Teichroew, D., Robicheck, A., and Montalbano, M., An
analysis of criteria for investment and nancing decisions
under certainty, Management Science Vol. 12 Nr. 3,
November 1965, 151179.
[12] Global Investment Performance Standards

11

Further reading

1. Bruce J. Feibel. Investment Performance Measurement. New York: Wiley, 2003. ISBN 0-47126849-6

12

External links

Economics Interactive Lecture from University of

South Carolina
GIPS Global Investment Performance Standards
2010, CFA Institute

13

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