Full lesson guide
How the idea works
IRR is the discount rate that makes the present value of all project cash flows add up to zero. For a project with one initial payment and later positive cash flows, compare IRR with the required return. If two projects are mutually exclusive, compare the rupee value each adds at a suitable rate. Cash flows that switch signs several times can produce several IRRs.
- IRR
- The rate at which the project breaks even in present-value terms.
- Mutually exclusive projects
- Alternatives where choosing one rules out doing the other.
Apply it to a decision
Fictional example · Rank two mutually exclusive machine upgrades
A costs ₹1 lakh and returns ₹1.4 lakh in a year. B costs ₹5 lakh and returns ₹6.5 lakh in a year. The business can do either project and uses a 10% hurdle.
Which has the higher IRR and which adds more value?
- Set up the problem. For one year, divide proceeds by cost and subtract one. IRR is 40% for A and 30% for B.
- Work it out. A adds ₹1.4 ÷ 1.10 − ₹1 ≈ ₹0.27 lakh. B adds ₹6.5 ÷ 1.10 − ₹5 ≈ ₹0.91 lakh.
- Read the result. Choose B if both are feasible and the 10% rate fits both risks. It adds more rupees even though A earns the higher percentage.
Before you use it
Use NPV to rank mutually exclusive projects at an appropriate hurdle.
Common mistake. A higher IRR can come from a small project that creates less total value.
Read or watch next
MIT OpenCourseWare video · Capital budgeting
Part II compares IRR with other ways of judging a project.