1 October 2026
4 mins read
The internal rate of return or IRR is one of the most useful financial metrics to understand the return-generating potential of a project. In financial terms, IRR is the discount rate at which a project’s net present value is zero. By comparing the IRR of two projects, a manager can decide which one to invest in. Hence, IRR helps companies allocate capital to projects that have better return-generating potential than other projects. As IRR is expressed in terms of percentage, it is simple to understand and interpret. While it has many benefits, it has a few limitations as well. For example, if two projects have vastly different durations or cash flows, then IRR cannot be used to compare them.
The internal rate of return (IRR) denotes the return an investment can generate. While calculating it, we exclude external factors, like cost of capital and inflation. Hence, it is called the “internal” rate of return.
IRR is extremely important, as it helps business leaders assess the profitability of an investment. In most cases, an investment with a higher IRR is better than another with a lower IRR. Read this blog, as it explains the meaning of the internal rate of return, how the internal rate of return works, and many other aspects related to it.
IRR meaning starts with a simple example. Suppose a company is thinking about investing in a factory. It knows how much it will spend building the factory, known as capital expenditure, which counts as a cash outflow today.
The company must then estimate future cash inflows from the factory. These inflows are typically estimated year by year. Say the factory has a productive life of 20 years, with its value reaching zero at the end of that period. For each of these 20 years, the company estimates expected cash inflows.
The discount rate at which the present value of all future cash inflows equals the capital expenditure is the internal rate of return.
No external factor, such as cost of capital or inflation, is needed for this calculation. Only the estimated cash inflows and outflows matter, which explains the full form of IRR: it measures return using only what happens "inside" the investment itself.
This section walks through the IRR formula, a worked spreadsheet example, and how IRR is used to compare two investment projects side by side.
The internal rate of return can be calculated using the following formula:
0 = CF0 + [CF1/(1+IRR)] + [CF2/(1+IRR)2] + [CF3/(1+IRR)3] +……..+ [CFn/(1+IRR)n]
In this formula, CF0 stands for the initial investment in a project. CF1, CF2, CF3….. CFn stands for cash flows in future years. N stands for the duration of the project.
Consider the project below. It has a capital outlay in Year 0 (today), so cash flows in Year 0 show as negative.
From Year 1 to Year 10, the project generates cash inflows. All these numbers go into a spreadsheet. At 5% IRR, the NPV is ₹8,191.
Since IRR is the rate at which NPV equals zero, the Goal Seek function in MS Excel can be used to find the exact IRR.
| IRR | 5.00% | |
|---|---|---|
| Cash flows | Present Value | |
| Year 0 | -1,00,000 | -1,00,000 |
| Year 1 | 10,000 | 9,524 |
| Year 2 | 15,000 | 13,605 |
| Year 3 | 15,000 | 12,958 |
| Year 4 | 20,000 | 16,454 |
| Year 5 | 20,000 | 15,671 |
| Year 6 | 15,000 | 11,193 |
| Year 7 | 15,000 | 10,660 |
| Year 8 | 10,000 | 6,768 |
| Year 9 | 10,000 | 6,446 |
| Year 10 | 8,000 | 4,911 |
| Net Present Value (NPV) | 8,191 |
Using Goal Seek, the IRR comes out to 6.74%, as shown below:
| IRR | 6.74% | |
|---|---|---|
| Cash flows | Present Value | |
| Year 0 | -1,00,000 | -1,00,000 |
| Year 1 | 10,000 | 9,368 |
| Year 2 | 15,000 | 13,165 |
| Year 3 | 15,000 | 12,333 |
| Year 4 | 20,000 | 15,405 |
| Year 5 | 20,000 | 14,432 |
| Year 6 | 15,000 | 10,140 |
| Year 7 | 15,000 | 9,500 |
| Year 8 | 10,000 | 5,933 |
| Year 9 | 10,000 | 5,558 |
| Year 10 | 8,000 | 4,166 |
| Net Present Value (NPV) | 0 |
Suppose a company wants to invest in one of two projects, A or B, with the same capital expenditure and duration. Using Goal Seek, the respective IRRs come out as follows:
| IRR | 14.54% | 12.20% | ||
|---|---|---|---|---|
| Project A's Cash Flows | Present Value | Project B's Cash Flows | Present Value | |
| Year 0 | -50,000 | -50,000 | -50,000 | -50,000 |
| Year 1 | 15,000 | 13,096 | 16,000 | 14,260 |
| Year 2 | 20,000 | 15,246 | 18,000 | 14,299 |
| Year 3 | 20,000 | 13,311 | 18,000 | 12,744 |
| Year 4 | 10,000 | 5,811 | 12,000 | 7,572 |
| Year 5 | 5,000 | 2,537 | 2,000 | 1,125 |
| Net Present Value (NPV) | 0 | 0 |
Project A's IRR is higher than Project B's, which would normally favour Project A on this metric alone. However, IRR comparisons assume similar scale and duration, and don't capture every factor relevant to a final investment decision.
IRR, CAGR, and ROI all measure investment performance, but each captures something different.
ROI looks only at total profit relative to investment, ignoring time. CAGR assumes one smooth annual growth rate with no interim cash flows. IRR is the only one of the three that accounts for both the size and timing of every cash flow in a series.
Metric | What It Measures | Accounts for Timing? | Best Suited For |
ROI | Net profit divided by initial investment, as a percentage | No | Simple, single cash flow comparisons |
CAGR | Annualised growth rate, assuming reinvestment and no interim flows | No | Mutual fund performance reporting (AMFI standard) |
IRR | Annualised return accounting for all cash flows and their timing | Yes | Projects or investments with multiple, uneven cash flows |
A simple example: investing ₹1,00,000 today and receiving ₹30,000, ₹40,000, and ₹50,000 at the end of Years 1, 2, and 3, respectively, works out to an IRR of approximately 8.9%, since this accounts for exactly when each rupee was received. (Source: SEBI)
Additional Read: How to Calculate Mutual Funds Returns
The internal rate of return helps investors assess which project to invest in. Let us say that a company has to decide whether to invest in Project X or Project Y. It can compare the IRR of these two projects and invest in the project with a higher IRR. Besides, often companies do not have sufficient financing to invest in all projects. In such a situation, they can compare the IRR of various projects and decide which projects are worth pursuing.
The internal rate of return also helps investors compare a project’s actual IRR with its projected IRR. If the actual rate is higher than the projected rate, it is a good sign. However, if the actual rate is lower than the projected rate, then investors need to analyse why this is the case.
Once they have identified the reasons for a lower than expected IRR, they can take corrective action.
Additional Read: Call and Put Options: Meaning, Types & Examples
The main benefits of internal rate of return are explained below:
Consider the time value of money: Several financial metrics, like payback period, do not consider the time value of money. However, the internal rate of return considers the time value of money. The fact is that the value of money deteriorates over time due to factors like inflation. Hence, by considering the time value of money, IRR provides investors with a realistic picture of a project.
Based on cash flows: IRR is based on cash flows. However, many other indicators use net profit, which is an accrual concept. While calculating net profit, a business considers all those incomes that it should have received and not those that it actually received. Similarly, it considers all the expenses that it ought to have paid and not the expenses it actually paid. However, cash flows are based on the actual cash inflows and outflows of a business. Hence, IRR is a better indicator.
Easy to interpret: As IRR is expressed in terms of a percentage, it is easy to understand and interpret. If a company has to decide whether to invest in a project, it has to check whether its IRR is higher or lower than a comparable project.
While the internal rate of return has its advantages, it has certain limitations as well, which are explained below:
Should not be used alone: When IRR is used alone, it can result in misleading conclusions. Let us say that Project A has 12% IRR and Project B has 15% IRR. It seems that Project B is better than Project A. However, Project A is for 20 years, while Project B is for only 5 years. As the duration of these projects is considerably different, IRR alone will not help an investor make a decision.
Does not consider the relative size of an investment: Let us take the same example. Suppose Project A and B have the same duration. However, Project A requires an investment of ₹100 crores, while Project B needs an outlay of ₹10 crores. As the respective outlay on the projects are vastly different, the net returns they will generate in absolute terms are also considerably different. Hence, IRR will not help us make a decision.
Application of IRR in Stock Market Investments: The internal rate of return can be applied effectively while making stock market investments. Suppose a stock is trading at ₹100 today, you can calculate its IRR by estimating future cash flows from it, like dividends and its selling price. If you think its IRR is sufficiently high, you can invest in it, else you can avoid it.
How Traders Use IRR to Analyze Stocks: Typically, traders buy stocks for a short period of time. Once they buy a stock, they have to estimate the price at which they will be comfortable selling it. By using the price they have bought a share and the price they would like to sell it at, they can estimate its IRR and make a decision accordingly.
IRR is the rate at which the net present value of an investment is zero. It is calculated by using this formula:
0 = CF0 + [CF1/(1+IRR)] + [CF2/(1+IRR)2] + [CF3/(1+IRR)3] +……..+ [CFn/(1+IRR)n]
Suppose a company has multiple projects to choose from. It can decide which project to invest in using IRR. Typically, a project with a higher IRR is better than a project with a lower IRR. A company can also compare a project’s actual IRR with its estimated IRR to assess its performance.
IRR is the rate at which a project’s NPV is zero. However, NPV is the difference between the present value of a project’s cash inflows and the present value of its cash outflows.
The internal rate of return (IRR) does not consider the relative size of an investment and the duration of an investment. In case, two projects have significantly different capital expenditure or duration, then it becomes meaningless to compare their IRR
Yes, IRR can be used to evaluate stock market investments by calculating the cash outflows and inflows from such investments and then finding the discount rate at which their NPV is zero.
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THIRD PARTY PRODUCT DISCLAIMER
Bajaj Financial Securities Limited is a distributor for Non-Broking Products/Services such as Mutual Funds, Mutual Funds SIP, IPO, Bonds, Insurance, PMS, Global Investing, any other third-party products/services. These are not Exchange Traded Products, and we are only acting as distributors. All disputes with respect to the distribution activity, would not have access to SCORES/ODR, Exchange investor redressal forum or Arbitration mechanism. Please refer to the detailed disclaimer for Third-Party Products.
As per SEBI circular no. SEBI/HO/MIRSD/MIRSD-PoD-1/P/CIR/2023/84 dated June 08, 2023, Stockbrokers are required to upstream the entire client funds lying with them to the Clearing Corporation. Based on client’s request the funds’ release request must be placed with the Clearing Corporation. Based on the internal process and cut-off timelines of the Clearing Corporation the funds will be released to the Stock Broker. In view of this new process, as specified by the regulatory and the cut-off time of Clearing Corporation/Banks processing the funds, Bajaj Financial Securities Limited cannot commit the exact time for releasing funds payout to its client. Clients are requested to note that, Bajaj Financial Securities Limited will not be responsible for any inconvenience caused to clients due to delay in release of funds payout, including fines, delayed charges, defaults, etc.
