How to Calculate Internal Rate of Return (IRR)

In project management, financial analysis is crucial when deciding which projects to undertake. One of the most widely used metrics is the Internal Rate of Return (IRR). IRR evaluates a project’s profitability by calculating the rate of return at which the present value of the project’s cash inflows equals the present value of its cash outflows. In other words, IRR is the discount rate that makes the Net Present Value (NPV) of a project equal to zero.

Understanding IRR can help project managers, financial analysts, and executives make informed decisions about whether a project will provide sufficient financial benefits to the organization. If a project’s IRR exceeds the organization’s expected rate of return, it is generally considered a financially viable investment.

Why IRR Matters for Project Managers

For project managers, IRR is more than just a number—it’s a tool for decision-making. By evaluating a project’s IRR, you can determine:

• Whether the project will generate returns above the company’s minimum required rate of return

• Which projects are worth prioritizing when resources are limited

• How to compare multiple projects and allocate capital efficiently

For example, suppose your company has a minimum required rate of return of 10%. If Project A has an IRR of 12% and Project B has an IRR of 15%, both projects exceed the threshold. However, Project B may be more attractive if the organization can only fund one initiative.

Use MS Excel to calculate IRR

For example, we’ll start by leveraging our original project’s cash flows…

From the above statistics, we’ll construct our MS Excel spreadsheet as below…

If you look at the IRR formula in cell I5, you will notice that the expected rate of

return (cell A1) is not leveraged. However, we still want to see the expected rate

of return on this sheet as a comparison point with our calculated IRR’s in cells I5

and I9.

IT Project Budget and Cost Management

The IRR formula just leverages the IRR function and the range of values that

represent the project’s cash flows (cells B5 through H5 and cells B9 through H9).

Since the IRR of both projects are above the 10% expected rate of return

threshold, both projects are acceptable to undertake. If you only had one choice

of project to choose from, you’d select Project A. This leads us to the below

consideration for using IRR.

Pitfall of using IRR

A pitfall of using IRR is that it does not distinguish between the timing of

negative and positive cash flows. For example, the below cash flows represent

projects C and D.

If you calculate the IRR for these projects, you will arrive at the MS Excel

Calculations as noted below...

As you can see, both projects are above the expected rate of return so both

apparently can proceed. However, let’s take a look when you calculate the Net Present Value (NPV) of these projects…

Now, project B does not look appealing at all and should NOT be undertaken

despite having the same IRR as project A. What is happening here?

What’s going on is that the IRR formula is not differentiating if the cash flow for

a particular year is positive (cash flow) or negative (payment) for a project.

Using IRR and NPV Together

For project managers, the best practice is to use IRR and NPV together. While IRR shows the expected percentage return, NPV provides a monetary value of the project’s potential profitability. A project with a high IRR but negative NPV may not be beneficial, while a project with a slightly lower IRR but positive NPV could deliver more tangible benefits.

When presenting project evaluations to executives, including both IRR and NPV can strengthen your case and demonstrate a comprehensive financial analysis.

Practical Considerations

When using IRR for project selection:

1. Consider the scale of investment: Large projects may have lower IRR but higher total returns.

2. Check for multiple IRRs: Projects with unconventional cash flows (multiple sign changes) may produce more than one IRR.

3. Use realistic expected rates of return: Align your expected return with organizational benchmarks.

4. Complement with sensitivity analysis: Evaluate how changes in cash flows impact IRR and NPV to account for risk.

By understanding these considerations, project managers can make informed, data-driven decisions about which projects to approve.

Conclusion

The Internal Rate of Return (IRR) is a fundamental metric for evaluating project profitability. It provides insight into the rate of return at which a project’s cash inflows and outflows balance out. However, relying solely on IRR can be misleading due to its inability to account for cash flow timing and project scale. Combining IRR with NPV, sensitivity analysis, and a thorough understanding of project risks ensures better financial decisions.

Proper financial analysis allows project managers to prioritize projects, allocate resources efficiently, and communicate value to stakeholders with confidence.