Financial Metrics · Intermediate level · 4 min read ·
What is IRR?
IRR, the internal rate of return, is the annual rate that sums up a project's projected cash flows in a single number: what is contributed at the start and what is expected back later. Technically, it is the discount rate at which NPV equals zero. It is a projection, not a fixed result.
In 30 seconds
- IRR is the rate at which the present value of the flows equals the initial contribution.
- It is a compound annual rate: not the total increase divided by the years.
- It depends on projected flows, so it changes if the project performs differently.
Why should you care?
A project has cash flows on different dates over many years. IRR turns them into an annual rate you can read next to others.
- You compare projects of different lengths in one unit: a rate per year.
- You understand how IRR, NPV and a model's discount rate relate.
- You read a projected figure knowing which assumptions it rests on.
Think of it as the average speed of a trip
A trip has fast and slow stretches, but at the end you can say "we averaged 60 an hour". IRR does something similar with a project's flows: stronger years and weaker years are summed up in a single annual rate.
How does IRR work?
- 1
Lay out the flows over time
The initial contribution is negative; what is expected back each year is positive.
- 2
Try a rate
Discount each flow at that rate and add them up: that is the NPV at that rate.
- 3
Adjust until NPV is zero
If NPV is positive, raise the rate; if negative, lower it. The rate that brings it to zero is the IRR. A spreadsheet does this with its IRR function.
- 4
Compare it with the reference rate
For flows like these, an IRR above the model's discount rate is the same as a positive NPV.
The formula
0 = −C₀ + F₁ ÷ (1 + IRR)¹ + F₂ ÷ (1 + IRR)² + … + Fₙ ÷ (1 + IRR)ⁿ
- C₀
- = initial contribution
- Fₜ
- = projected flow in year t
- n
- = number of years in the model
An example with numbers
As plain arithmetic, unrelated to any project: you contribute 100 units today and receive 121 units at the end of year two, with nothing in year one.
| Contribution today | 100 |
|---|---|
| Year 1 flow | 0 |
| Year 2 flow | 121 |
| Total increase | 21% |
| IRR | 10% a year |
The total increase is 21%, but IRR is 10%, not 10.5%: 100 × 1.1 = 110 and 110 × 1.1 = 121. IRR counts that year one's growth also grows in year two.
Where do you see it at Circular Urban?
On solar project sheets, the Financial Models section shows each model's IRR along with NPV, payback and ROI. It is a non-binding reference projection built on production, tariff and cost assumptions: the result of your participation is subject to the project's actual performance and to the participation agreement.
- Solar project sheets, in Financial Models: IRR.
- The Risks & Mitigants section, which explains what could move those assumptions.
What changes in your finances once you get it
You read annual rates critically
You know a total increase isn't divided by the years: the equivalent annual rate always comes out a little lower.
You ask about the assumptions
Before looking at a projected rate, you check which production, prices and costs it depends on.
You also look at size
A high rate on a small amount can leave fewer pesos than a lower rate on a larger one.
Common mistakes
- Myth
A 10% IRR means I'll receive 10% of my contribution every year.
- In reality
IRR sums up all projected flows in one rate. Actual flows can vary a lot from year to year, and some years can be zero.
- Myth
Between two projects, the one with the higher IRR is always better.
- In reality
IRR doesn't say how many pesos are generated or for how long, and it doesn't measure risk. Read it with NPV, the term and the project's risks.
- Myth
The IRR on the project sheet is the one I'll get.
- In reality
It is a non-binding reference projection. The result depends on the project's actual performance and the terms of your participation.
Test yourself
You contribute 100 units today and receive 144 units at the end of year two, with nothing in year one. What is the IRR?
Keep learning
What comes next
This content is educational. Every participation carries risks inherent to the project, including the possibility of partial or total loss, and results are subject to each project's actual performance.
