Internal Rate Of Return

What is IRR? Understanding the Internal Rate of Return

IRR is the annualised effective compounded return rate reflecting the return on investment achieved when the investment reaches its break-even point.

Written by : Knowledge Centre Team

2025-12-24

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10 minutes read

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Understanding the Internal Rate of Return (IRR) is crucial for evaluating investment profitability in today's dynamic financial landscape. IRR serves as a powerful tool in capital budgeting for comparing different projects. As interest rates and market conditions evolve in 2026, having a clear grasp of IRR enables investors to make informed decisions by identifying the investment option that promises the highest effective return relative to its cost of capital.

Key Takeaway:

  • Internal Rate of Return (IRR) is a metric that helps you estimate the annual return of an investment to decide whether it is fruitful or not.

  • It is calculated keeping the Net Present Value (NVP) zero, marking the break-even point. 

  • There are many ways to calculate IRR, such as using a financial calculator, MS Excel, or a mathematical formula. 

  • You can use IRR to calculate profits in SIPs, ULIPs, NPS, IDCW Mutual Funds, and market-linked pension plans.

  • IRR may not be relevant for the real world as it does not consider the time value of money. 

What is the Internal Rate of Return (IRR) Meaning?

The Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the expected return on an investment. The IRR is the discount rate that makes the net present value of an investment equal to zero.

It is also a good way to compare different projects within the same company.

When evaluating potential investment opportunities, investors typically opt for the highest expected return, represented by the IRR, which meets or increases the minimum percentage necessary for the investments. The higher the IRR, the higher the profit from the investment.

IRR Calculation Example

Assume a project has an initial investment of ₹1,000 and is expected to generate cash flows of ₹200, ₹300, and ₹400 over the next three years.

Here is how to calculate internal rate of return:

IRR = [₹200 + ₹300 + ₹400] / [3 * ₹1,000] = 0.14. In this IRR example, the project has an IRR of 14%.

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Desclaimer-

The above calculation and illustration of figures are indicative only and not on actual basis.

You should use the Internal Rate of Return when comparing different investments. It is a good way to measure the return on an investment, as it timing of cash flows.

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Main Components of the IRR Formula

The Internal Rate of Return formula is a critical tool in finance that is used to evaluate the performance of an investment opportunity.

Let's break down the components of the Internal Rate of Return formula:

  • Net Present Value: The NPV represents the summation of future cash flows from an investment, discounted to their present value at the IRR. For IRR calculation, NPV is set to zero to determine the IRR that renders the investment's NPV neutral, marking the break-even point.

  • Cash Flow: It consists of all monetary transactions associated with an investment, including inflows such as profits, revenue, or dividends and outflows like expenses, interest, or loan payments.

  • Number of Periods: N signifies the duration over which the investment extends. Time periods are usually discrete, such as years, quarters, or months, depending on the nature of the investment.

  • IRR: The Internal Rate of Return denotes the discount rate required to equate the present value of cash flows with the initial investment. 

  • Initial Investment (CF₀): This refers to the upfront expenditure required to initiate the project or investment.

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Did You Know?

India’s merchant battery storage systems became profitable in 2024, with 2025 projects targeting 17% IRR due to falling costs and power exchange operation


Source: TOI

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How to Calculate IRR With Example? 

Now that you know the IRR meaning, let's move forward to understanding how is IRR calculated. There are quite a few methods to calculate:

  • Using the Financial Calculator: Financial calculators have built-in IRR functions that automatically calculate the discount rate from your cash flow series.
    1. Enter the cash flows for the investment, making sure to list them in chronological order
    2. Press the "IRR" button on the calculator
    3. The calculator solves for IRR automatically.
    4. Enter the required rate of return (This is the minimum return you would accept for investing)
    5. Press the "Calculate" button on the IRR calculator
    6. The output will show the Internal Rate of Return for the investment
  • Using MS Excel: Excel's built-in IRR function simplifies the calculation by automatically solving the NPV=0 equation.
    1. Enter your investment's cash flows in a table in chronological order (negative initial investment first).
    2. Use the =IRR(range) function directly to calculate the internal rate of return for your investment
    3. Interpret your results

A positive IRR indicates that your investment will generate a return greater than the interest rate. In contrast, a negative IRR indicates that your investment will create a return less than the interest rate.

  • Using Math IRR Formula With Example: Learn how to calculate irr manually through this equation using iteration or trial-and-error:
    1. Arrange the cash flow in increasing order, i.e., negative values first, followed by positive values.
    2. Calculate the cumulative cash flow.
    3. Use the following IRR formula for the calculation:

IRR = [∑(CFn * (1 + r)n)]/∑(CFn)

Where,

CFn = Cash flow for period n
r = Rate of return
n = Number of cash flows

  • Internal Rate of Return Solved Examples: Suppose a company is considering replacing its machinery. Here are the costs and returns associated:
    1. Initial investment: ₹500000
    2. Annual incremental increase: ₹200,000
    3. Replacement value: ₹45,270
    4. Asset lifespan: 3 years

Assuming the Internal Rate of Return (IRR) to be 13%, the calculation would proceed as follows:

Year
Cash flows
Discounted cash flows
Computation

0

 

 

-5,00,000

 

 

-500000

 

 

(5,00,000 * 1) 

 

 

1

 

 

2,00,000

 

 

176991

 

 

2,00,000 * (1/1.13)1 

 

 

2

 

 

2,00,000

 

 

156229

 

 

2,00,000 * (1/1.13)2 

 

 

3

 

 

2,00,000

 

 

138610

 

 

2,00,000 * (1/1.13)3 

 

 

4

 

 

45,270

 

 

27765

 

 

45,270 * (1/1.13)4 

 

 

With the IRR formula, the sum of discounted cash flows approaches zero, yielding an NPV of zero, indicating that the discount rate is optimal. A rate of 13% minimises both positive and negative cash flows. Thus, it represents the best return on investment. The company's cost of capital stands at 10%. Given that the IRR surpasses this rate, the project is viable for selection.

formula-internal rate of return

How to Use Internal Rate of Return (IRR) for Investments? 

To calculate the rate of return, the investor must first determine the cash flows associated with the investment. These cash flows can be positive (inflows) or negative (outflows).

IRR is then calculated as the rate at which the present value of the investment's cash flows equals the initial investment. In other words, it is the discount rate that makes the net present value of the investment equal to zero.

The higher the Internal Rate of Return, the more profitable the investment. For this reason, investors often use IRR to compare different investment opportunities.

Recommended Reading:- What are Financial Assets?

When Not to Use Internal Rate of Return (IRR)?:

The Internal Rate of Return is a good measure to use when comparing investment opportunities, but there are some potential drawbacks.

  • The biggest issue with using IRR is that it assumes that cash flows are reinvested at the same rate. This may not hold good in the real world.

  • Finally, IRR can give conflicting results when there are multiple periods of positive and negative cash flows.

Internal Rate of Return Vs Net Present Value:

IRR and NPV are two methods of investment appraisal.

IRRNPV
IRR indicates the discount rate at which the NPV of a project is zeroNPV is the present value of cash inflows from a project minus the present value of cash outflows
IRR is a measure of the expected return on investment.NPV is a measure of the profitability of an investment
IRR shows the percentage return that the project will yieldNPV shows the money that a project will produce
IRR is focused on breaking even on cash flowNPV is focused on the project surplus

Investments Where IRR Helps to Judge Performance:

IRR is useful for investments with regular cash inflows/outflows, such as:

RR helps compare SIP/annuity returns to lump-sum CAGR.

Do remember to convert your monthly IRR to an annual rate of return before you can compare it with CAGR or compounded annual growth rate.

You should also consider the different scenarios and components of the project. You must have a firm understanding of the risks involved in the project and the probability of success of the project. For more clarity on the potential impact of the project on your business, you should use multiple methods to calculate the return on investment before deciding.

Limitations of Using IRR in Real-World Scenarios

The usage of the Internal Rate of Return seems like a beneficial option unless you plan to apply it in reality.

Why? Well, take a look at the following points:

  • Assumption of reinvestment at IRR: When calculating the IRR, you must assume that interim cash flows are reinvested at the same rate. This is pretty unrealistic when the Modified Internal Rate of Return (MIRR) exists, and the issue is addressed by assuming reinvestment at the cost of capital.
  • Multiple or no IRRs: In the real world, situations are possible where the cash flows change directions many times. It is non-conventional, and at times when there will be many or no IRRs, it will become difficult to interpret the results. 
  • Ignorance of the Project Size: The IRR formula does not understand the scale of investment. A project with a high internal rate of return in a small investment does not necessarily mean absolute return, as a large project with a smaller IRR.
  • Ranking Conflicts with NPV:IRR and NPV are both used to calculate the performance of an investment. In that case, each may show different rankings and create confusion. Meanwhile, the Net Present Value method is considered more reliable by many investors. 
  • It is Not Applicable for Different Project Durations: A long-term project with a steady return is beneficial for many compared to short-term projects with a higher IRR, and the formula does not account for duration differences.

Summary

IRR’s capital budgeting metric helps determine the growth rate a new project or investment option can achieve. Accept projects where IRR exceeds the cost of capital. Higher IRR indicates higher potential returns. If you plan to make the right investment choice for better future growth, you can check out the investment options offered by Canara HSBC Life Insurance.

Thoughtfully designed investment plans can help you grow your wealth and stay financially secure during emergencies.

Glossary:

  1. NPV: The present value of all future cash inflows minus outflows, discounted at a required rate. Positive NPV indicates profitability.
  2. ULIPs: Combine life cover with market-linked investments Premiums split between coverage and fund units for growth + protection.
  3. MIRR: It fixes IRR's reinvestment flaw by assuming interim cash flows are reinvested at cost of capital or safe rate.
  4. CAGR: It measures smoothed annual return over multiple periods, ideal for comparing lump-sum investments to SIP IRR.
  5. SIP: It involves regular fixed investments in mutual funds, perfect for rupee-cost averaging and IRR performance tracking.
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FAQ’s For Internal Rate of Return (IRR):

IRR, or Internal Rate of Return, is a financial metric used to assess the profitability of an investment. It represents the rate at which the net present value (NPV) of cash flows from an investment equals zero.

A 20% IRR indicates that the investment is expected to generate a return of 20% annually, reflecting its profitability relative to the initial investment.

A 100% Internal Rate of Return suggests that the investment doubles in value, which may seem favourable. However, it's essential to assess other factors such as risk, time horizon, and sustainability to determine the overall attractiveness of the investment.

Yes, a negative Internal Rate of Return reflects that the present value of expected cash flow is less than outflows, indicating an investment loss where returns fail to recover the initial outlay.

The Internal Rate of Return (IRR) rule is a standard guideline in capital budgeting that states: 

  • Accept the project if its IRR exceeds the cost of capital (or required rate of return/hurdle rate).

  • Reject the project if its IRR is below the cost of capital. 

This rule is based on the premise that a project is financially viable if its expected rate of return (IRR) is higher than the cost of the funds used to finance it.

IRR is annualized compounded return considering cash flow timing; simple ROI is total profit/initial investment ignoring time value.

With irregular/alternating cash flows (multiple sign changes), IRR produces multiple or no solutions.

Yes, small high-IRR project vs. large low-IRR project; IRR ignores scale/absolute value.

It is advisable to use both IRR and NPV when evaluating investments: IRR provides the percentage rate of return, helping assess the efficiency of the investment, while NPV offers the absolute monetary value of profit, which gives a clearer picture of the overall profitability. Using both metrics together helps resolve potential conflicts in investment ranking and supports better decision-making.

Disclaimer - This article is issued in the general public interest and meant for general information purposes only. The views expressed in this blog are solely those of the writer and do not necessarily reflect the official policy or position of Canara HSBC Life Insurance Company Limited or any affiliated entity. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the blog or the information, products, services, or related graphics contained in the blog for any purpose. Any reliance you place on such information is therefore strictly at your own risk. You should consult with a qualified professional regarding your specific circumstances before taking any action based on the content provided herein.

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