## What is IRR?

The **Internal Rate of Return (IRR) **is the annualized interest rate at which the initial capital investment must have grown to reach the ending value from the beginning value.

The IRR measures the compounded return on an investment, with the two inputs being the value of the cash inflows / (outflows) and the timing (i.e. dates).

Table of Contents

- How to Calculate IRR
- IRR Formula
- What is a Good IRR?
- How to Analyze IRR in Commercial Real Estate (CRE)
- Excel XIRR vs. IRR Function: What is the Difference?
- What Causes IRR to Increase or Decrease?
- What are the Limitations to Internal Rate of Return?
- IRR Calculator | Excel Template
- 1. LBO Model Entry Assumptions
- 2. Cash Flow Analysis Example
- 3. IRR Calculation Example
- 4. Multiple of Money Calculation Example (MoM)
- 5. LBO Returns Analysis (IRR and MoM)

## How to Calculate IRR

The internal rate of return (IRR) metric is an estimate of the annualized rate of return on an investment or project.

**Capital Budgeting**→ The internal rate of return (IRR) is the discount rate at which the net present value (NPV) on a project or investment is equal to zero, i.e. the discounted series of cash flows are of equivalent value to the initial investment.**Investment Analysis**→ The internal rate of return (IRR) is the potential rate of return on an investment, expressed on an annualized basis. The IRR is a tool to analyze the expected yield on an investment to ensure the return meets the minimum required rate of return (“hurdle rate”) specific to the investor.

The higher the internal rate of return (IRR), the more profitable a potential investment will likely be if undertaken, all else being equal.

Unlike the multiple of on invested capital (MOIC), another metric tracked by investors to measure their returns, the IRR is considered to be “time-weighted” because it accounts for the specific dates that the cash proceeds are received.

The manual calculation of the IRR metric involves the following steps:

- Divide the Future Value (FV) by the Present Value (PV)
- Raise to the Inverse Power of the Number of Periods (i.e. 1 ÷ n)
- From the Resulting Figure, Subtract by One to Compute the IRR

## IRR Formula

The formula for calculating the internal rate of return (IRR) is as follows:

**Internal Rate of Return (IRR)**= (Future Value

**÷**Present Value)

**^**(1

**÷**Number of Periods)

**–**1

Conceptually, the IRR can also be considered the rate of return, where the net present value (NPV) of the project or investment equals zero.

The alternative formulas, most often taught in academia, involve solving for the IRR for the equation to hold true (and require using a financial calculator).

- 0 = CF t = 0 + [CF t = 1 ÷ (1 + IRR)] + [CF t = 2 ÷ (1 + IRR)^2] + … + [CF t = n ÷ (1 + IRR)^ n]

Or, an alternative method to solve for IRR is the following:

- 0 = NPV Σ CF n ÷ (1 + IRR)^ n

## What is a Good IRR?

In the context of a leveraged buyout (LBO) transaction, the minimum internal rate of return (IRR) is usually 20% for most private equity firms.

However, the IRR can be easily distorted by the earlier receipt of cash proceeds.

For instance, suppose a private equity firm anticipates an LBO investment to yield an 30% internal rate of return (IRR) if sold on the present date, which at first glance sounds great.

But from a more in-depth look, if the multiple on invested capital (MOIC) on the same investment is merely 1.5x, the implied return is far less impressive.

Why? The 30% IRR is more attributable to the quicker return of capital, rather than substantial growth in the size of the investment.

I have a problem with this irr

I get decimals instead of percentage

Pressing Ctrl + Shift + 5, or Alt, H, P are two methods to convert into percentage format, thanks.

The cash flow her means operating cash flows only or total cash flows ??

Hi, Asutosh, In this case, the cash flows are the initial equity investment and the final payout to equity holders at the end, so only cash flows at the beginning and the end. We assume the operating cash flows along the way are used to pay down debt, so what… Read more »

How does the $25M assumption happen? Where is that assumption from/based in?

Hi, Austin,

The $25mm assumption here is to illustrate the idea that the value of the business grows each year (probably due to growth in EBITDA), so if you sell it in a later year, you will sell for a higher price.

BB

Re: IRR For the calculation of IRR denoted on the IRR & MoM Calculation worksheet and explained in the Internal Rate of Return (IRR) document, are the Cash Flows in Years1 through Year 5 Pre-tax or After-tax? Example: Let’s assume that the $85m is the full cash investment. If the… Read more »

Greg:

You don’t tax affect the cash investment… that’s literally the amount invested. The cash inflows should be after-tax.

Best,

Jeff

What if my investment has multiple cash outflows, like the fees associated with licensing software? Let’s say it is a 5-year project and every year I have cash outflows of $125,000? All the IRR examples I’ve seen only have an initial cash outflow. Can I use IRR when I have… Read more »

Hi, Zim,

Yes, IRR can handle cash outflows over multiple years, as long as there are cash inflows as well, at least at the end.

BB