The Internal Rate of Return (IRR) is a financial metric that supports business owners in deciding whether or not to proceed with a new project or investment, by indicating how profitable a new venture might be.
“Any project or investment decision ties up capital,” says Simon Gray, Head of Business at the Institute of Chartered Accountants in England and Wales (ICAEW). “IRR is used to help determine if a decision is a good one and, in a situation where several options exist, the best one.”
What is the Internal Rate of Return (IRR)?
The IRR shows the annual rate of growth that a potential investment is expected to generate. Companies use it to understand how profitable a new investment or project might be, based on its projected cash flows over a set period of time.
In this way, IRR considers the time value of money, says Gray. It recognises that money received in the present is of more value than money received in the future. That’s because money today is known and certain, which means it can be invested in your business to make even more money, or deposited into a high-interest account. Whereas money in the future is more uncertain and risky.
What is IRR used for?
IRR is used to appraise project and investment decisions, says Gray. “It measures the expected compound annual rate of return that is anticipated to be generated from a project or investment,” he continues. In other words, the annual growth rate of an investment over time.
Business owners often use IRR to compare and prioritise potential investments and projects. Those with the highest IRRs are most likely to generate the highest return for a business. And those with the lowest IRRs will likely be the least profitable new ventures to invest in. In this way, IRR supports you in deciding which projects to invest in over others.
Investors such as venture capital and private equity investors also use IRR extensively, to decide which early-stage businesses are likely to generate the best return on investment. The company with the highest rate of return is usually the strongest contender.
Calculating the IRR for a new venture involves estimating your future cash flows to work out how profitable the new venture might be. The American Express® Business Gold Card gives you extended payment terms of up to 54 days¹, helping you to better manage your cash flow and provide more accurate estimates for your IRR calculations.
How to calculate internal rate of return
While the concept behind IRR sounds straightforward, the IRR formula itself - as shown below - can appear daunting. IRR can be determined easily with spreadsheets, so although it is rarely necessary to perform the calculation by hand, it's useful to understand the formula and its components.
IRR formula
IRR is the rate at which the net present value of all future cash inflows and outflows for a project is zero. Or in other words, how quickly the break-even point is reached. It is always expressed as a percentage that reflects the expected yield from an investment. The IRR calculation formula is:
IRR: 0 = NPV = t∑t=1 Ct/(1+IRR)t − C0
Element one: net present value (NPV)
Net present value is the value of all present and future cash flows from a company, project or investment, over their lifespan. It considers the difference in value of money today and money in the future. For example £20 today is worth more than £20 in five years' time. That’s because you can invest that £20 now to make a return whereas, in the future, interest rates and inflation can gradually degrade the value of your money so it doesn’t go as far as it does today.
NPV considers something known as a discount rate. This is the rate by which you reduce future cash flows, so that they equal the value that they would be today. For example, it could be how much return shareholders can expect to make, or how much interest you pay on debt. NPV then takes each of your future sources of cash flow, applies the discount rate and subtracts the total initial investment in the project.
NPV = Cash flow1/(1+r)1 + cash flow2/(1+r)2 - initial investment
Element two: net cash flow during period t (Ct)
This is the total amount of money coming into your business from a particular revenue stream in a given time period after all expenses have been paid. In other words, the difference between money coming in (inflows) and money going out (outflows).
Element three: Initial investment cost (C0)
This is the total amount of money you will invest in the project or venture today.
Element four: Number of time periods (t)
This is the total number of time periods of the project or investment. For example, if you plan on working on the new venture for five years, this would equal 5.
IRR calculation example
Imagine you have £10,000 today. You are considering two ways of investing it: in a new product line for your business or in expanding into a new market. How do you know which is the best investment? To make an informed decision, you need to calculate the IRR for both options.
Calculating IRR
To work out the IRR of the new product line, start by opening an excel spreadsheet and entering the projected cash flow values. The initial investment in the project, which in this case is £10,000, is entered as a negative sum to reflect the outlay. Then enter the cash flow the new product line is expected to generate each year for the five-year period.
Excel spreadsheets have an in-built IRR formula function, so in an empty cell, type '=IRR' and you will be prompted to enter a value range. Select the cells containing the cash flow values and the IRR is calculated as 17%.
New product line
| Year | Cash flow |
| Zero | -10,000 |
| One | 1,000 |
| Two | 1,500 |
| Three | 3,000 |
| Four | 5,000 |
| Five | 8,000 |
You can then perform the same calculation with the cash flow projections from the new market expansion option. The projected cash flow from spending your £10,000 on expansion into a new market offers an IRR of 14%. Going back to the original question of where to invest your £10,000 for the best return, the answer is in the new product line, since it generates a higher IRR.
Expansion into a new market
| Year | Cash flow |
| Zero | -10,000 |
| One | 500 |
| Two | 2,000 |
| Three | 2,500 |
| Four | 3,000 |
| Five | 8,800 |
What is a good Internal Rate of Return?
“The higher the IRR, generally the better the investment decision,” says Gray. However, he adds that what represents a good IRR does vary between businesses and projects.
“There may be a multitude of reasons to pursue a specific project, both financial and non-financial,” Gray notes. For example, businesses often have units that don’t generate revenue but instead provide another benefit, such as acquiring a new type of customer or raising brand awareness. “Calculating IRR helps a business ensure the financial part makes good sense,” says Gray.
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