Internal Rate of Return

IRR is the most widely quoted performance metric in private equity, venture capital, real estate, and corporate capital budgeting. When a private equity firm says it generated a 25% IRR on a portfolio company, it means the discount rate that equates the present value of all distributions (dividends, proceeds from sale) to the initial investment is 25% per year. The investment decision rule is straightforward: accept projects where IRR exceeds the required rate of return (WACC or hurdle rate); reject projects where it falls short.

IRR cannot be solved with a closed-form algebraic expression when there are multiple cash flow periods; it requires iterative numerical methods or a financial calculator. Spreadsheet functions (IRR in Excel or Google Sheets) handle this automatically. As a check, an investment with an IRR equal to WACC will have an NPV of exactly zero — breaking even in economic terms.

IRR has well-documented limitations compared to NPV. The reinvestment rate assumption is the most serious: IRR implicitly assumes that all intermediate cash flows are reinvested at the IRR itself. A project with a 30% IRR implicitly assumes each cash flow received during the project life is reinvested at 30% — an unrealistic assumption for most real-world investments. In practice, cash can typically only be reinvested at the cost of capital (WACC), which is far lower.

A second problem is the possibility of multiple IRRs. When a project has non-conventional cash flows — positive, then negative, then positive again (as in a mine that requires large reclamation costs at end of life) — the NPV equation can have multiple roots, producing multiple IRRs, none of which is clearly 'the' return. The Modified IRR (MIRR) was developed to address both these limitations.

Finally, IRR can mislead when ranking mutually exclusive projects of different scales. A small project returning $1 million on a $5 million investment (IRR = 20%) outranks a large project returning $10 million on a $100 million investment (IRR = 10%) by IRR, but the large project creates nine times more absolute value. For capital allocation decisions, NPV is the correct ranking criterion; IRR is best used as a hurdle-rate comparison, not a ranking tool.