What is the internal rate of return?
The internal rate of return, or IRR, is the discount rate at which a project's net present value equals zero. It expresses an investment's return as a single annual percentage.
It is the rate the investment effectively earns. That makes it intuitive to compare against a benchmark: if the IRR beats your cost of capital, the investment is worth making.
How IRR is calculated.
IRR is the rate that solves net present value equals zero across the cash flows. There is no clean formula for it, so it is found numerically, and this tool solves it by searching for the rate that zeroes the NPV.
You provide the upfront investment and the yearly cash flows; the tool does the iteration. Because it is a search, IRR needs a sign change in the cash flows, an outflow followed by inflows, to exist.
A worked example.
Invest 1,000 today and receive 500 a year for three years. The IRR, the rate that makes those discounted inflows exactly equal the 1,000, works out to about 23.4%.
What is a good IRR?
The benchmark is your cost of capital: an IRR above WACC means the investment earns more than it costs to fund, and a higher spread is better. There is no universal number, since the right bar depends on the business and the risk of the cash flows.
IRR and NPV are two views of the same cash flows. Comparing it with how fast acquisition pays back grounds the return in a familiar SaaS measure.
How it is used.
Use IRR to compare investments against a hurdle rate and against each other, accepting those whose IRR clears your cost of capital. Treat it as one of two lenses, alongside NPV, rather than the only one.
For an operating business, the returns that clear the hurdle come from growth that does not consume cash to produce, which is part of the case for returns that clear the hurdle.