Internal rate of return: Understanding this metric and how to calculate it can help you invest more wisely

• Internal Rate of Return (IRR) is a formula used to evaluate the returns of a potential investment.
• IRR calculates the projected annual growth rate of a specific investment over time.
• IRR is often used to compare similar investments, or in capital planning and budgeting.

Internal rate of return (IRR) is one of several popular formulas used to evaluate prospective investments. It allows you to calculate an investment's potential gains over a certain period of time and determine if it's a worthwhile use of your or your company's funds.

As Daniel Garza, a CFA with Intercontinental Wealth Advisors, explains: "IRR is often used to determine the feasibility of investment projects."

Are you looking to assess a new investment's potential? Here's how calculating its IRR can help.

Understanding how IRR works

IRR is used to calculate the potential annual returns of an investment over time, while taking into account cash flow - the money coming in and out. It's often used to determine where a company's funds are best directed.

For example, you might use it to evaluate whether Investment A or Investment B is the better use of your capital. IRR could also help determine if establishing a new operation or expanding your existing one is the more profitable option.

IRR is most often used in conjunction with hurdle rate - or the minimum amount of returns you need to bring in. Many companies use their weighted average cost of capital (WACC) as their base hurdle rate.

"Once the IRR is obtained, it's compared to the hurdle rate in order to determine if the project is viable," Garza says. "If the IRR is higher than the hurdle rate, then the project adds value."

Quick tip: IRR is best used when comparing investments with similar durations and in tandem with other analyses, such as payback period and net present value (NPV).

IRR formula and calculation

The IRR formula is complex, so it's rarely calculated manually. In most cases, investors use an IRR calculator or an Excel spreadsheet, which has a built-in function to determine a project's IRR.

Nevertheless, the exact formula looks like this:

When calculating IRR, you're solving for an NPV of zero. You'll then need the number of years you plan to hold the investment (N), as well as your expected cash inflows and outflows for those periods (CF1, CF2, etc.). From there, you can determine a project's internal rate of return.

Here's an example: Say you're on the fence about purchasing a $100,000 piece of equipment. You project it will bring in $40,000 in annual profits each year, until year six, when it's likely to be out of date or no longer functioning. At that point, you'll sell the equipment for $10,000.

The IRR, in this case, would be 29.7%. If that IRR is higher than your hurdle rate - or the IRR of another similar investment you're considering - it's probably a smart use of your funds.

Quick tip: If you're calculating IRR manually, it takes trial and error until the NPV equals zero. To make it easier, consider using Excel's built-in IRR function. There is also an XIRR (extended IRR) function if you expect your cash flow to be more erratic.

ROI vs IRR

IRR and simple ROI, or return on investment, are both ways to evaluate the earnings of a specific investment. The main difference is that IRR calculates the potential returns that can be expected over a certain time period, while simple ROI gives you the actual return on the investment, without factoring in timing.

"The biggest problem with ROI is that it doesn't take into account the passage of time, essentially ignoring the time value of money," says Robert R. Johnson, professor of finance at Creighton University.

IRR also requires more detailed data than ROI does. ROI is more "simplistic," as Johnson puts it, requiring just two numbers: Your investment's current value and the initial cost of that investment. For IRR, you'll need an accurate picture of your total costs, cash flow, and holding period.

The financial takeaway

IRR can help you evaluate the potential of a new investment or endeavor, as well as compare it with other options you might be considering. Just make sure you incorporate other analyses and consider using a calculator or Excel's IRR function to ease the process. If you need help determining whether a new investment is a smart move or not, consider contacting a financial analyst or advisor. They can help you run the numbers and make the best choice.