IRR: the key tool to evaluate project profitability

Having reliable financial metrics and parameters not only improves a business’s accuracy and efficiency, but also helps reduce risks and maximize opportunities. In a competitive environment, making data-driven decisions makes the difference between success and failure. One key indicator in this regard is the Internal Rate of Return (IRR), a financial metric used to assess the viability and profitability of investment projects.

This method provides insight into a project’s ability to generate income sufficient to cover or exceed the initial investment, allowing companies and individuals to make informed decisions about how to allocate resources. For this reason, IRR is one of the most important tools within training in a Master’s in Financial Management or a Global MBA, two of the most relevant academic paths for those who want to build a career in business.

What is IRR used for?

IRR is a key metric used to evaluate the profitability of an investment project. It measures the annual percentage return that a project generates on the invested capital. If the IRR is higher than the cost of capital, i.e., the WACC (Weighted Average Cost of Capital, which reflects the average cost of financing a project through debt and equity), the project can be considered viable.

A high IRR usually reflects a project with strong potential that can contribute to an organization’s growth. In addition, this metric facilitates comparison between different initiatives, allowing companies to prioritize those that promise higher returns. It also plays a key role in decision-making, as investors can use it to assess whether to finance new projects or continue investing in ongoing operations.

Among the advantages of IRR, its uniformity as a standard indicator stands out, making it applicable to projects of different nature. Likewise, its expression in percentage terms makes it an intuitive and easy-to-understand tool, even for those without advanced financial training.

However, overestimating the benefits of IRR can be harmful. Assuming that cash flows are constant and reinvested at the same IRR can lead to overly optimistic expectations. For example, if we imagine a project with an IRR of 20%, but its actual cash flows cannot be reinvested at that same rate due to market constraints, the total return would be lower than expected, negatively affecting the initial project evaluation.

In addition, IRR can be problematic when comparing projects of different durations, since short-term projects often show a higher IRR than long-term ones, which may not reflect their true profitability. In summary, IRR is a powerful tool, but it should be used alongside other indicators such as Net Present Value (NPV) and WACC to obtain a more complete view.

How is IRR calculated?

IRR is calculated as the discount rate that makes the net present value (NPV) of a project equal to zero. In other words, it is the rate at which the discounted cash flows of a project equal the initial investment. The calculation follows this principle:

IRR formula:

Where:

• CFt = Net cash flow in period t.
• t = Period (0, 1, 2, …, n).
• IRR = Internal rate of return to be found.
• n = Total number of periods.

Steps to calculate IRR:

1. Define cash flows: identify outflows (initial investment) and inflows (future benefits) of the project.
2. Apply the formula: substitute cash flow values and solve the equation.
3. Iterate or use financial tools: since IRR cannot be calculated directly, trial-and-error methods or tools such as Excel (IRR function) or financial calculators are used.

Due to the complexity of the formula, most analysts use tools such as spreadsheets (Excel, Google Sheets), specialized financial software, or MATLAB, R, and Python with specialized libraries. In Excel, the function allows quick calculation by entering cash flows.

Examples of Internal Rate of Return (IRR)

Example 1: Project A vs. Project B

• Project A: initial investment €2,000, with cash flows of €1,200 in year 1 and €1,500 in year 2.
• Project B: initial investment €2,000, with cash flows of €800 per year for three years.

IRR calculation:

• Project A: IRR of 20.5%.
• Project B: IRR of 15.7%.

Conclusion: Project A has a higher IRR and would be more attractive if only percentage returns are considered.

Example 2: Comparison with WACC

A company has a WACC of 10% and is considering two projects:

• Project X: IRR of 12%.
• Project Y: IRR of 8%.

Conclusion: since Project X’s IRR exceeds the WACC, it creates value for shareholders. Project Y is not profitable because its IRR is below the cost of capital.

Example 3: Use in financing

An investor evaluates two options:

• Project 1: IRR of 7%.
• Project 2: IRR of 5%.

If the goal is to minimize financing costs, the investment with the lower IRR (5%) would be chosen, as it implies lower financial cost.

Why is IRR important in decision-making?

The Internal Rate of Return (IRR) is a key indicator for evaluating investment profitability and works effectively alongside metrics such as Net Present Value (NPV) and Weighted Average Cost of Capital (WACC), offering a more complete perspective for complex investment decisions.

Although IRR is a useful standard for measuring profitability, using it in isolation can lead to biased decisions. It should be considered alongside other financial metrics to avoid overly optimistic projections. By combining IRR with NPV, WACC, and a detailed risk analysis, companies can make more informed and strategic investment decisions.