Saving & investing

Internal rate of return (IRR): Definition, Formula and Example

IRR is a discount rate that makes the net present value of a specified series of cash flows equal to zero.

Scope: General financial concept; examples are hypothetical.

Other names and related labels: IRR; Money-weighted return.

How it works

IRR incorporates the size and timing of contributions and distributions. Periodic IRR assumes equally spaced cash flows; a dated calculation needs an explicit day-count convention. The root may be absent or nonunique when cash flows change sign more than once.

0 = Σ[cash flow at period t / (1 + IRR)^t], including the initial cash flow at t = 0

Use signed cash flows from one consistent viewpoint. A periodic IRR is a rate per cash-flow period unless explicitly annualized.

$1,000 invested and $1,100 received a year later

Treat the investment as an outflow and the receipt as an inflow.

  1. At 10%: −$1,000 + $1,100 / 1.10 = $0.
  2. The single-period rate is $1,100/$1,000 − 1 = 10%.

The annual IRR is 10% for these two cash flows.

Exactly one year; no intermediate payments or extra fees.

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A higher IRR is not always the better project

Projects of different scale or timing may rank differently by NPV. For cash flows −100, +230 and −132 at annual intervals, both 10% and 20% are IRRs. A single displayed root is not necessarily an unambiguous investment return.

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