Internal Rate of Return (IRR): Formula, Importance, vs. ROI

Internal rate of return (IRR) is the expected average return of an investment. IRR is commonly used in corporate finance and is similar to the compound annual growth rate (CAGR), which is more commonly used by stock investors.

IRR is a part of the net present value (NPV) equation. A project's IRR is the return rate that makes the net present value of the project equal $0.

Loading paragraph...

A man in a factory works on new capital purchases. — Image source: Getty Images.

Loading image...

Loading paragraph...

A graphic of the NPV formula — NPV formula

Loading image...

Setting NPV to zero and solving for "r" -- the discount rate in this equation -- produces a value that represents a project's IRR. If a company's management has a choice to pursue one of two projects, then they can compute the IRR for each project and pursue the project that is the most profitable.

Using a fictional example, imagine that FoolCo is considering either embarking on an expansion project or purchasing a new machine. Both projects would be initially costly but would later boost the company's profits. The projected cash inflows and outflows for each proposed project are as follows:

Loading paragraph...

https://g.foolcdn.com/editorial/images/197442/irr-excel.JPG — Image source: The Motley Fool

Loading image...

In Excel, you can use the program's XIRR function to solve for "r" -- the IRR -- for each project. The XIRR function first asks for the dates, followed by the cash flows, and then a guess at the IRR of 20%. The guess is not required, and Excel defaults to a guess of 10% if none is entered. Pressing enter causes the function to iterate to instantly produced the correct "r" value that results in the NPV equaling zero.

Using the XIRR function to compute the IRR for both projects demonstrates that the expansion project would produce an internal rate of return of 14.5%, while the new machine purchase would generate an IRR of 26.5%. From a purely financial standpoint, FoolCo should choose to buy the new machine.

Loading paragraph...

Loading pitch...

Loading paragraph...

Related investing topics

Loading paragraph...

How to Invest in Stocks

Are you ready to jump into the stock market? We've got you.

How to Invest $100

You can start your investment journey with a small sum of money. Here's what to do with it.

What Is Real Estate Management?

Balancing time and cash flow can get tricky as an investor. Enter the real estate manager.

Loading hub_pages...

Loading paragraph...

Loading pitch...

About the Author

Mike Price is a 23 year-old Masters of Finance graduate who first started learning about investing on the Motley Fool when he was 13. He is currently seeking a job.

XMFMichaelPrice

Mike Price has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.