what is irr used for 
in capital planning one popular scenario for irr is comparing the profitability of establishing new operations with that of expanding existing operations for example an energy company may use irr in deciding whether to open a new power plant or to renovate and expand an existing power plant while both projects could add value to the company one will likely be the more logical decision as prescribed by irr note that because irr does not account for changing discount rates it s often not adequate for longer term projects with discount rates that are expected to vary irr is also useful for corporations in evaluating stock buyback programs clearly if a company allocates substantial funding to repurchasing its shares then the analysis must show that the company s own stock is a better investment that is has a higher irr than any other use of the funds such as creating new outlets or acquiring other companies individuals can also use irr when making financial decisions for instance when evaluating different insurance policies using their premiums and death benefits the consensus is that policies that have the same premiums and a high irr are much more desirable note that life insurance has a very high irr in the early years of the policy often more than 1 000 it then decreases over time this irr is very high during the early days of the policy because if you made only one monthly premium payment and then suddenly died your beneficiaries would still get a lump sum benefit another common use of irr is in analyzing investment returns in most cases the advertised return will assume that any interest payments or cash dividends are reinvested back into the investment what if you don t want to reinvest dividends but need them as income when paid and if dividends are not assumed to be reinvested are they paid out or are they left in cash what is the assumed return on the cash irr and other assumptions are particularly important on instruments like annuities where the cash flows can become complex finally irr is a calculation used for an investment s money weighted rate of return mwrr the mwrr helps determine the rate of return needed to start with the initial investment amount factoring in all of the changes to cash flows during the investment period including sales proceeds using irr with waccmost irr analyses will be done in conjunction with a view of a company s weighted average cost of capital wacc and npv calculations irr is typically a relatively high value which allows it to arrive at an npv of zero most companies will require an irr calculation to be above the wacc wacc is a measure of a firm s cost of capital in which each category of capital is proportionately weighted all sources of capital including common stock preferred stock bonds and any other long term debt are included in a wacc calculation in theory any project with an irr greater than its cost of capital should be profitable in planning investment projects firms will often establish a required rate of return rrr to determine the minimum acceptable return percentage that the investment in question must earn to be worthwhile the rrr will be higher than the wacc any project with an irr that exceeds the rrr will likely be deemed profitable although companies will not necessarily pursue a project on this basis alone rather they will likely pursue projects with the highest difference between irr and rrr as these will likely be the most profitable irr may also be compared against prevailing rates of return in the securities market if a firm can t find any projects with an irr greater than the returns that can be generated in the financial markets then it may simply choose to invest money in the market market returns can also be a factor in setting an rrr analyses will also typically involve npv calculations at different assumed discount rates irr vs compound annual growth ratethe cagr measures the annual return on an investment over a period of time the irr is also an annual rate of return however the cagr typically uses only a beginning and ending value to provide an estimated annual rate of return irr differs in that it involves multiple periodic cash flows reflecting that cash inflows and outflows often constantly occur when it comes to investments another distinction is that cagr is simple enough that it can be calculated easily irr vs return on investment roi companies and analysts may also look at the return on investment roi when making capital budgeting decisions roi tells an investor about the total growth start to finish of the investment it is not an annual rate of return irr tells the investor what the annual growth rate is the two numbers normally would be the same over the course of one year but won t be the same for longer periods roi is the percentage increase or decrease of an investment from beginning to end it is calculated by taking the difference between the current or expected future value and the original beginning value divided by the original value and multiplied by 100 roi figures can be calculated for nearly any activity into which an investment has been made and an outcome can be measured however roi is not necessarily the most helpful for lengthy time frames it also has limitations in capital budgeting where the focus is often on periodic cash flows and returns limitations of irrirr is generally ideal for use in analyzing capital budgeting projects it can be misconstrued or misinterpreted if used outside of appropriate scenarios in the case of positive cash flows followed by negative ones and then by positive ones the irr may have multiple values moreover if all cash flows have the same sign i e the project never turns a profit then no discount rate will produce a zero npv within its realm of uses irr is a very popular metric for estimating a project s annual return however it is not necessarily intended to be used alone irr is typically a relatively high value which allows it to arrive at an npv of zero the irr itself is only a single estimated figure that provides an annual return value based on estimates since estimates of irr and npv can differ drastically from actual results most analysts will choose to combine irr analysis with scenario analysis scenarios can show different possible npvs based on varying assumptions as mentioned most companies do not rely on irr and npv analyses alone these calculations are usually also studied in conjunction with a company s wacc and an rrr which provides for further consideration companies usually compare irr analysis to other tradeoffs if another project has a similar irr with less up front capital or simpler extraneous considerations then a simpler investment may be chosen despite irrs in some cases issues can also arise when using irr to compare projects of different lengths for example a project of a short duration may have a high irr making it appear to be an excellent investment conversely a longer project may have a low irr earning returns slowly and steadily the roi metric can provide some more clarity in these cases although some managers may not want to wait out the longer time frame investing based on irrthe internal rate of return rule is a guideline for evaluating whether to proceed with a project or investment the irr rule states that if the irr on a project or investment is greater than the minimum rrr typically the cost of capital then the project or investment can be pursued conversely if the irr on a project or investment is lower than the cost of capital then the best course of action may be to reject it overall while there are some limitations to irr it is an industry standard for analyzing capital budgeting projects irr exampleassume a company is reviewing two projects management must decide whether to move forward with one both or neither its cost of capital is 10 the cash flow patterns for each are as follows project aproject bthe company must calculate the irr for each project the initial outlay period 0 will be negative solving for irr is an iterative process using the following equation 