What Is Internal Rate of Return?

IRR is one of the most sophisticated capital budgeting metrics used by FP&A teams. While ROI gives a simple percentage return, IRR accounts for the time value of money and the specific timing of cash flows, making it a more accurate measure of investment performance.

Conceptually, IRR answers the question: "What annualised rate of return does this investment earn?" If a project has an IRR of 18%, it is equivalent to earning 18% per year on the invested capital, accounting for the timing of all inflows and outflows.

The decision rule is straightforward: accept investments where IRR exceeds the company's cost of capital (hurdle rate). If the hurdle rate is 12% and a project's IRR is 18%, the project creates value. If IRR is 8%, the project destroys value relative to the cost of funding it.

IRR is particularly useful for comparing projects of different sizes and durations. A small project might have higher IRR than a large one, even if the large project has higher NPV. This distinction between IRR (rate of return) and NPV (total value created) is important for capital allocation.

However, IRR has limitations. It can produce multiple solutions for projects with non-conventional cash flows (alternating positive and negative). It assumes interim cash flows are reinvested at the IRR itself, which may be unrealistic. Modified IRR (MIRR) addresses this by assuming reinvestment at the cost of capital.

For UK businesses, IRR calculations should use after-tax cash flows that reflect corporation tax payments, capital allowance benefits, and any available tax incentives like R&D tax credits or the Enterprise Investment Scheme.