With the Internal Rate of Return (IRR), you can assess how attractive an investment really is. Put simply, it shows the annual return an investment generates over its entire lifetime. That is exactly why IRR is widely used across finance, from investment banking and private equity to corporate finance.
In this article, we take a step by step look at how IRR works, how to calculate and apply it, and how you can use this knowledge to stand out in finance interviews.
The Internal Rate of Return (IRR) describes the discount rate at which the present value of all future cash flows exactly equals the initial investment. In other words, IRR is the return at which an investment mathematically generates neither a profit nor a loss. This is precisely why it is well suited for comparing different investments.
To calculate IRR, all future cash flows of an investment are set in relation to the initial investment, and the discount rate is determined at which the net present value equals zero.
The formula is:
Before applying it, let us briefly look at the individual components:
In theory, you are looking for the discount rate r at which the sum of all discounted cash flows equals zero. In practice, IRR is almost always calculated using Excel or a financial calculator, as it cannot be solved directly.
Imagine you invest 1,000 euros in a project today. After one year, you receive 600 euros, and after two years, another 600 euros. Your initial investment C₀ is −1,000, and the cash flows C₁ and C₂ are both +600.
The IRR is the discount rate at which the present value of these two repayments equals exactly 1,000 euros. If the IRR is, for example, 13 percent, this means the investment generates an annual return of 13 percent in mathematical terms.
The Internal Rate of Return (IRR) is used so frequently in finance because it expresses an investment’s return as a simple percentage. This makes it easy to compare different investments, even when the size and timing of cash flows differ.
IRR is particularly relevant in the following three areas:
Companies use IRR to assess whether a project creates value. If IRR is above the WACC (Weighted Average Cost of Capital), the project is considered attractive. When comparing multiple projects, the one with the highest IRR is often preferred, provided strategy and risk are aligned.
In private equity, IRR is the key metric for evaluating deals and funds, as it considers both the size and timing of cash flows.
In investment banking, IRR is used in M&A and LBO analyses to assess whether target returns are achieved. In LBOs, target IRRs often range between 20 and 25 percent.
Although the Internal Rate of Return (IRR) is a very popular and intuitive metric, it has several important limitations you should be aware of:
For this reason, IRR is almost always considered together with Net Present Value (NPV) in practice, as NPV shows how much value a project actually creates. In interviews, you score particularly well if you demonstrate that you understand both the strengths and limitations of IRR.
Here you will find common finance interview questions on the Internal Rate of Return (IRR), along with concise answers to help you prepare for interviews in investment banking, private equity, or corporate finance.
The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of an investment equals zero. Put simply, it shows the annual return an investment generates over its lifetime, while also accounting for the timing of cash flows.
In practice, IRR is compared to a company’s cost of capital. If IRR is above the WACC, the project creates value and is considered attractive. If it is below, the return does not cover the cost of capital and the project should be rejected.
IRR assumes that all cash flows generated during the investment period can be reinvested at the same rate, which is often unrealistic. In addition, alternating inflows and outflows can lead to multiple IRRs, reducing clarity.
Moreover, IRR does not account for project size. A small project can have a very high IRR but create little value, while a larger project with a lower IRR may generate more overall value. This is why IRR should always be considered together with NPV.
The Internal Rate of Return (IRR) is an important return metric in finance that helps you evaluate and compare the attractiveness of investments. It is widely used in investment banking, private equity, and corporate finance to assess projects, deals, and investment decisions.
If IRR is above the cost of capital (WACC), an investment is considered value creating. At the same time, IRR has well known limitations, such as reinvestment assumptions or challenges when comparing projects of different sizes. In practice and in finance interviews, you should therefore always consider IRR together with Net Present Value (NPV).
