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IRR (Internal Rate of Return): definition, formula, and how to use it

IRR explained: what internal rate of return means, how to calculate IRR, and when IRR can be misleading (use NPV too).

Updated 2026-02-16

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IRR example (upfront $100k; 5-year cash flows)

What IRR means

IRR (Internal Rate of Return) is the discount rate that makes NPV equal zero. You can interpret IRR as the annualized return implied by a series of cash flows under standard assumptions.

IRR definition

IRR is the rate r where NPV(r) = 0.

How to calculate IRR (step-by-step)

  • List the initial investment (negative cash flow) and future cash flows by period.
  • Use an IRR function or solver to find the rate r where NPV = 0.
  • Validate by checking NPV at that rate is near zero.
  • Compare the IRR to your hurdle rate (MARR).

IRR example

If you invest $100k and receive $30k per year for 5 years, the IRR is about 15%.

Why IRR is useful

  • Compare opportunities with multi-year cash flows.
  • Compare to a hurdle rate (MARR) to see if a project clears your required return.
  • Works best for projects with one upfront investment followed by positive cash flows.

When IRR can mislead

  • Multiple IRRs can exist when cash flows change sign multiple times.
  • IRR can hide scale (high IRR but low NPV).
  • IRR implicitly assumes reinvestment at the IRR (often unrealistic).

Best practice: use IRR with NPV

  • Use NPV at your discount rate (MARR) to measure value created in dollars.
  • Use IRR as a quick comparison, then validate with NPV and payback.
  • Test sensitivity by varying discount rate and cash flow assumptions.

FAQ

Is higher IRR always better-
Not necessarily. Higher IRR is attractive, but a small project can have high IRR and still create little value. Use NPV to compare total value created at a consistent required return.
What if IRR is undefined-
Some cash flow patterns don't produce a single IRR (or any IRR). In those cases, rely on NPV at a chosen discount rate instead.

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