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Internal Rate of Return

Discount rate that makes the NPV of all cash flows equal zero.

irrAlso: IRR

Definition

Internal Rate of Return is the discount rate at which the present value of future cash flows equals the initial investment, resulting in NPV = 0. It represents the compound annual return earned on invested capital considering the timing of all cash flows.

Why It Matters

IRR is the gold standard return metric in private equity and project finance. It accounts for both magnitude and timing of cash flows, making it essential for comparing investments with different time horizons.

Formula

= IRR(cash_flow_range)

Excel IRR function applied to cash flow series.

Mathematical Notation

0 = \sum_{t=0}^{n} \frac{CF_t}{(1+IRR)^t}

Alternative Approaches

XIRR= XIRR(values, dates)

Cash flows occur on irregular dates

Modified IRR= MIRR(values, finance_rate, reinvest_rate)

Different reinvestment rate assumptions needed

Typical Ranges

Best Practices

Use XIRR for irregular dates. Compare to hurdle rate and cost of capital. Be aware of IRR limitations with non-conventional cash flows (multiple sign changes).

Common Mistakes

✕Not using XIRR for irregular cash flows
✕Ignoring multiple IRR solutions with non-conventional cash flows
✕Comparing IRRs across different time horizons without adjustment
✕Forgetting to include all cash flows (management fees, transaction costs)

Pro Tips

✓Gross IRR vs Net IRR: always clarify fees and carried interest
✓Time-weighted return is better for manager performance measurement
✓Check your IRR against MOIC for reasonableness
✓High IRR on small amounts < Lower IRR on large amounts (consider total profit)

Audit & Governance

Risk Level

Critical

Approval Required

director

Sensitivity

confidential

Track Changes

Yes

Learning Path

beginner

IRR answers: "What average annual return am I earning?" If you invest $100 and get $200 back in 5 years, IRR tells you the compound annual return.

intermediate

IRR considers timing - getting money back sooner increases IRR even if the total dollars are the same. This is why private equity loves dividends.

advanced

IRR can be misleading with non-conventional cash flows or when comparing projects of different sizes. Always pair with NPV and MOIC.

expert

Consider modified IRR (MIRR) with explicit reinvestment rate, especially for project comparison. PME (Public Market Equivalent) is better for benchmarking.

Used in Models

This variable is a key driver in the following financial models:

Standard LBO Model

private equity ma

Learn More

Deepen your understanding with these guided learning paths:

Valuation Models

intermediate•4-5 hours•6 modules

Decision & Risk Interpretation

advanced•2 hours•6 modules

LBO Modeling for Private Equity

advanced•4-5 hours•6 modules

Related Variables in returns

Multiple of Invested Capital

Total value returned divided by total capital invested.