What is IRR (Internal Rate of Return)?

The Internal Rate of Return is the discount rate at which the Net Present Value of all cash flows from a project equals zero. It represents the annualized effective compounded return rate that an investment is expected to generate, making it useful for comparing projects of different sizes and durations.

IRR answers the question: "What annual return does this investment generate?" If a project's IRR exceeds the company's cost of capital (hurdle rate), the project creates value. Private equity firms typically target IRRs of 20-30%, while corporate projects might have hurdle rates of 10-15%.

IRR is particularly popular in private equity because it captures both the magnitude and timing of returns. A deal that doubles money in three years has a higher IRR than one that doubles money in five years, even though both have the same total return (2x). PE firms are compensated on IRR-like metrics, which incentivizes quick value creation and exit.

However, IRR has known limitations. It assumes interim cash flows are reinvested at the IRR itself, which may be unrealistic for high-IRR projects. It can also produce multiple solutions for projects with unconventional cash flow patterns. In interviews, mentioning that you'd look at both NPV and IRR together shows nuanced financial thinking.

Real-world example

A private equity firm acquired a specialty chemical company for $400M, improved operations, and sold it for $1.2B four years later. The 3x return translated to an IRR of approximately 32%, well above their 20% hurdle rate.

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What is IRR (Internal Rate of Return)?

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