Internal Rate of Return (IRR) is the discount rate at which a project's net present value equals zero — the project's effective compound annual growth rate. An investment is attractive when IRR exceeds the cost of capital.
IRR is the rate that makes the NPV of all cash flows (initial investment plus future returns) equal to zero. It is calculated iteratively — there is no closed-form formula, but most spreadsheets and financial calculators solve it directly. The decision rule: if IRR > cost of capital (hurdle rate), the investment adds value and should be pursued. If IRR < hurdle rate, decline. For small business owners, IRR is most commonly used to evaluate equipment purchases, business expansions, real estate investments, and acquisition opportunities. A $100,000 equipment investment that generates $30,000/year in incremental operating profit over 5 years (assuming no residual value) has an IRR of approximately 15.2%. If the business's cost of capital is 10%, IRR exceeds the hurdle — invest. IRR has limitations: it assumes interim cash flows are reinvested at the IRR rate (which may be unrealistic for very high IRR projects), and it can give misleading results when cash flows change sign multiple times (multiple IRRs problem). For most straightforward small business investments — negative cash flow upfront, positive thereafter — IRR is reliable and intuitive. Modified IRR (MIRR) addresses the reinvestment assumption by specifying a separate reinvestment rate. The SBA's economic analysis guidance for 504 projects uses a modified version of IRR-equivalent analysis to evaluate community economic impact alongside financial return.
An investment is attractive if IRR exceeds your cost of capital. For most small businesses, that means IRR above 10–15% for stable returns, or 20%+ for higher-risk growth investments. Equipment, expansion, and acquisition investments with 15–25% IRR are typically solid. The bar rises with business risk.
ROI (Return on Investment) is a simple ratio: (gain − cost) / cost. It ignores timing — a 50% ROI over 1 year is very different from 50% over 10 years. IRR is time-value-adjusted: it's the annualized return that accounts for when cash flows occur. IRR is the more rigorous metric for multi-year investments.
Excel or Google Sheets: enter your cash flows in a column (negative investment, then positive returns) and use the IRR() function. Most financial calculators also have IRR built in. Manual calculation requires iterative trial and error — use a spreadsheet.