IRR Rule
Candlefocus EditorThe IRR rule states that if a project or investment's internal rate of return (IRR) is greater than the minimum required rate of return, also referred to as the hurdle rate, then the project or investment should be pursued. The required rate of return is the targeted minimum expected return on an investment that is being used to evaluate the attractiveness of projected profits from the proposed venture.
The IRR is the discount rate that makes the net present value (NPV) of all cash flows from the project or investment equal to zero. In other words, it is the expected compounded annual rate of return earned on invested capital during a project's life cycle. The higher the IRR, the better the return on the initial investment.
In order to calculate the IRR, a company will need to consider the project's expected cash inflows and outflows. These cash flows are then discounted back to the present time, often using a financial calculator, to adjust for inflation and the time value of money, and the discounted cash flows are then used to determine the project's IRR.
Ultimately, the IRR rule is used to measure the rate of return a company can expect from a given project or investment. If the project or investment's expected return meets the company's required rate of return, then it should be pursued. In some cases, a company may choose to pursue a project even if the IRR does not meet their required rate of return. This might be the case if there are other, less tangible, benefits or if the project does not require a great deal of initial capital outlay.
In summary, deciding whether or not to pursue a project is a key decision for any company. The IRR rule is one tool that can be used by businesses to help make that decision by evaluating the expected returns from a project compared to the minimum required rate of return the company is targeting. In some cases, a company might decide to pursue a project regardless of the IRR, if there are other, less tangible, benefits associated with the venture.