In any IT or capital investment review, saying “the NPV is positive” is rarely the end of the conversation. Sooner or later someone asks, “So what’s the return, in percent?” The metric that answers that question is the internal rate of return, or IRR.
In a survey of 392 U.S. CFOs, 75.7% said they always or almost always use IRR, making it as popular as NPV (74.9%) . By contrast, a 2008–2009 survey of companies listed on the Tokyo Stock Exchange found that only 24.5% used IRR always or often, while the simple payback period (50.2%) remained the dominant method support.microsoft. In many Japanese companies, IRR is a metric people know but rarely use with confidence.
This article explains the core rules for using IRR in an IRR investment decision, walks through a worked example based on an SAP IBP (Integrated Business Planning) implementation, and highlights the most common ways IRR can mislead you, along with how to avoid them.
IRR is the discount rate at which an investment’s net present value (NPV) equals exactly zero support.microsoft. Formally, IRR is the value of rrr that satisfies:
0=∑t=0nCFt(1+r)t0 = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t}0=t=0∑n(1+r)tCFt
Here, CFtCF_tCFt is the cash flow in year ttt (investments are negative, benefits are positive). IRR tells you the average annual compound rate at which the investment grows.
If you deposit JPY 1 million and receive JPY 1.1 million a year later, your interest rate is 10%. Likewise, if you invest JPY 1 million and generate JPY 1.1 million in benefits a year later, the IRR is 10%. IRR condenses a complex, multi-year stream of cash flows into a single rate you can compare just as you would a deposit rate.
A high IRR means little on its own. It becomes meaningful only when compared with the hurdle rate, the minimum return the company requires from an investment support.microsoft.
| Result | Decision |
| IRR > hurdle rate | Worth pursuing on a return basis |
| IRR = hurdle rate | Exactly meets the required return |
| IRR < hurdle rate | Reject, or revisit the plan |
The usual starting point for a hurdle rate is the weighted average cost of capital (WACC) support.microsoft. WACC is the average cost of debt and equity financing, weighted by their share of the capital structure, and is calculated as follows:
WACC=DD+E×rD×(1−t)+ED+E×rEWACC = \frac{D}{D+E} \times r_D \times (1-t) + \frac{E}{D+E} \times r_EWACC=D+ED×rD×(1−t)+D+EE×rE
Here, DDD is interest-bearing debt, EEE is equity, rDr_DrD is the cost of debt, rEr_ErE is the cost of equity, and ttt is the effective tax rate.
Applying the company-wide WACC to every project, however, can lead to poor decisions support.microsoft. In practice, companies add a risk premium to WACC that reflects each project’s specific risk support.microsoft. For example, efficiency improvements to existing operations warrant a lower premium, while new businesses or new technologies warrant a higher one.
Set the hurdle rate too high, and you risk rejecting long-term investments that take time to ramp up. Set it too low, and you may approve projects whose returns do not justify their risk.
When you evaluate a single project with conventional cash flows (an upfront investment followed by benefits), “IRR exceeds the hurdle rate” means exactly the same thing as “NPV discounted at the hurdle rate is positive.” That is because IRR is, by definition, the discount rate at which NPV equals zero. For an accept-or-reject decision on a single project, IRR and NPV therefore lead to the same conclusion.
The following example uses a fictional automotive parts manufacturer, Company A, to show how to apply IRR to an investment decision. All figures are illustrative.
The cash flows for an enterprise-wide SAP IBP rollout (Option A) are as follows.
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cash flow | −600 | 100 | 200 | 250 | 260 | 260 |
| Present value (10%) | −600.0 | 90.9 | 165.3 | 187.8 | 177.6 | 161.4 |
| Cumulative cash flow | −600 | −500 | −300 | −50 | 210 | 470 |
The results are:
With an IRR of 19.8%, well above the 10% hurdle rate, Option A is worth pursuing on a stand-alone basis. The gap of roughly 10 percentage points between IRR and the hurdle rate represents a margin of safety: the project remains viable even if some assumptions turn out worse than expected.
Suppose Company A also has the option of a pilot rollout at its main plant only (Option B). Options A and B are mutually exclusive: the company can choose only one.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | IRR | NPV (10%) | Payback |
| Option A: Enterprise-wide rollout | −600 | 100 | 200 | 250 | 260 | 260 | 19.8% | +183 | ~3.2 years |
| Option B: Pilot at main plant | −200 | 60 | 90 | 90 | 90 | 90 | 29.1% | +114 | ~2.6 years |
On IRR, Option B (29.1%) looks more attractive. Yet NPV, which measures how much value each option creates for the company, is about JPY 69 million higher for Option A (+JPY 183 million). Because IRR is a rate, it ignores differences in investment scale. When IRR and NPV rank mutually exclusive options differently, the rule is to choose the option with the higher NPV support.microsoft.
The chart above is an NPV profile, showing each option’s NPV across a range of discount rates. The two lines cross at a discount rate of 15.4%. Below that rate, Option A is preferable; above it, Option B is. With a hurdle rate of 10%, Company A should choose Option A.
If you want to use IRR to compare two options correctly, use incremental IRR. Incremental IRR is the IRR calculated from the difference between the two options’ cash flows support.microsoft.
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Difference (A − B) | −400 | 40 | 110 | 160 | 170 | 170 |
The incremental IRR is 15.4%, above the 10% hurdle rate. In other words, the additional JPY 400 million needed to move from Option B to Option A earns more than 10% on its own. Because the additional investment is justified, Company A should choose Option A support.microsoft. The incremental IRR is the same as the crossover rate in the chart.
The right way to compare options with IRR is not to pick the one with the highest IRR, but to ask whether the return on the additional investment, the incremental IRR, exceeds the hurdle rate.
IRR reacts strongly to shifts in when benefits arrive. The table below shows Option A’s IRR under less favorable assumptions.
| Scenario | IRR | NPV (10%) | Decision |
| Base case | 19.8% | +183 | Worth pursuing |
| Benefits 20% lower | 11.5% | +26 | Barely clears the hurdle |
| Initial investment 20% higher | 12.9% | +63 | Clears the hurdle |
| Go-live delayed by one year | 8.2% | −35 | Falls below the hurdle |
| Investment 20% higher and benefits 20% lower | 5.4% | −94 | Falls well below the hurdle |
The one-year go-live delay has the largest impact. Even though total benefits remain almost unchanged, IRR drops from 19.8% to 8.2%, below the hurdle rate. ERP and planning system implementations frequently suffer from go-live delays and slow adoption. When you base a decision on IRR, always test the risk to the timing of benefits, not just their size.
Investments that require a large additional outlay partway through have cash flows whose sign changes more than once. In such cases, there may be multiple IRRs, or none at all learn.microsoft.
For example, an investment with cash flows of −1,000, +2,300, and −1,320 has two IRRs: 10% and 20%. With a hurdle rate of 8%, both IRRs exceed the hurdle. Yet the NPV discounted at 8% is about −JPY 2 million, so the investment does not create value.
Excel’s IRR function returns only the first answer it finds, even when more than one exists support.microsoft. For investments with major mid-life system upgrades or decommissioning costs, do not rely on IRR alone; confirm the decision with NPV.
IRR is commonly described as implicitly assuming that interim cash flows are reinvested at the IRR itself, whereas NPV assumes reinvestment at the cost of capital learn.microsoft. The higher a project’s IRR, the less realistic this assumption becomes.
The modified internal rate of return (MIRR) addresses this issue. MIRR is calculated using separately specified rates for financing and for reinvestment support.microsoft. In our example, with both rates set at 10%, MIRR is 16.0% for Option A and 20.4% for Option B. MIRR makes the reinvestment assumption more realistic, but it still ignores differences in scale, so NPV should remain the final arbiter when comparing mutually exclusive options support.microsoft.
Note that the reinvestment assumption itself is debated in academic literature. Some researchers argue that ranking conflicts are actually caused by differences in cash flow timing, and that no reinvestment assumption is embedded in the IRR calculation support.microsoft. Whichever view you take, the practical conclusion is the same: prioritize NPV when choosing between mutually exclusive options.
The IRR function assumes that cash flows occur at regular intervals, such as annually or monthly support.microsoft. When implementation payments are concentrated mid-period, or go-live falls partway through a fiscal year, use the XIRR function, which accepts actual dates support.microsoft.
| Purpose | Function | Example |
| IRR for regular cash flows | IRR | =IRR(B2:G2) |
| IRR for cash flows on irregular dates | XIRR | =XIRR(B2:G2, B1:G1) |
| IRR with a specified reinvestment rate | MIRR | =MIRR(B2:G2, 10%, 10%) |
| NPV for comparison | NPV | =NPV(10%, C2:G2) + B2 |
| Incremental IRR | IRR | Add a row for the difference, then =IRR(B4:G4) |
Excel’s NPV function treats the first value in the range as a cash flow one year from now. For that reason, add the Year 0 investment outside the NPV function.
Because IRR expresses results as an intuitive annual percentage, it works well in executive presentations. Presenting IRR alone, however, hides scale and timing risks. We recommend summarizing the following five elements on a single page in any investment proposal:
U.S. CFO surveys show that, alongside NPV and IRR, hurdle rates, payback periods, and sensitivity analysis are widely used . A 2022 survey found that more than three-quarters of large firms still always or almost always use NPV and IRR, little changed from two decades earlier support.microsoft.
IRR converts an investment into a single annual rate of return and supports an accept-or-reject decision by comparing that rate with a hurdle rate. For a single project, it reaches the same conclusion as NPV, and it is easy for executives to understand.
At the same time, IRR ignores investment scale, is highly sensitive to shifts in the timing of benefits, and can produce more than one answer for certain cash flow patterns. When comparing multiple options, do not simply choose the one with the highest IRR; decide on NPV or incremental IRR.
In practice, the most persuasive investment cases use NPV as the primary decision criterion, IRR to show the rate of return and margin of safety, and sensitivity analysis to show the risks. For guidance on choosing an evaluation period and building up costs and benefits, see our related article, “SAP S/4HANA ROI: How to Build a 7-Year Business Case IT Leaders Can Defend.”
Parts of this article were developed with reference to generative AI suggestions and were reviewed, refined, and supplemented based on the author’s professional expertise and judgment.
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