Internal Rate of Return (IRR)

IRR expresses a project's profitability as a single percentage, which makes it easy to compare with a company's cost of capital or with other investments.

Take the same machine that costs 50,000 and produces 15,000, 18,000, 20,000 and 12,000 over four years. Its IRR is about 11.6%. That means the project earns the equivalent of 11.6% a year on the money invested. If the company's required return is 8%, the project clears the hurdle comfortably.

IRR usually cannot be calculated by hand; it is found by trial and error or with a spreadsheet or financial calculator.

IRR has limitations. It assumes cash flows received can be reinvested at the IRR itself, which may be unrealistic. For projects with unusual cash flows, such as large costs in later years, there can be more than one IRR or none at all. When comparing projects of different sizes, a smaller project may have a higher IRR but add less value overall. For these reasons, IRR is usually used alongside net present value rather than instead of it.