Understanding Internal Rate of Return (IRR) for the PMP Exam

Business professionals, including Project Managers, should have a clear understanding of the accounting term “Internal Rate of Return” (IRR) for its value in making informed financial decisions and in project selection choices. IRR is the “interest rate at which the cash inflow and cash outflow of the project equal zero” and is an economic method for project selection using capital budgeting. IRR as a concept is included in the Project Management Institute (PMI)’s Project Management Professional (PMP)® certification exam, so project managers need to know how it is calculated and used in business.

Internal Rate of Return (IRR) Defined

PMI’s A Guide to Project Management Body of Knowledge (PMBOK® Guide) online lexicon guide does not include the term “IRR formula PMP” or even “Internal Rate of Return.” Yet, the Internal Rate of Return concept may be referenced on the PMP exam due to the use of the IRR formula in project selection work.

Internal Rate of Return (IRR)The rate at which cash inflows equal cash outflows without consideration of external factors

Like IRR, the Return on Investment (ROI), is a formula for determining if the cost of an effort is made back, and if so, at breakeven, loss, or gain. However, IRR indicates annual growth whereas ROI predicts total growth. The “internal” part of “internal rate of return” reflects any environmental factors and external influences are excluded from the calculation. Determining the internal rate of return is achieved with a mathematical formula that uses net present value (NPV) and cash flow value.

Internal Rate of Return (IRR) and Net Present Value (NPV)

IRR and NPV have their own purpose but are related. At a high level, think of IRR and NPV as:

IRR is the discount rate at which the net present value (NPV) for the project is zero,

NPV is the total present value of cash flow for a project, and

IRR equals the discount rate that makes the NPV of future cash flows equal to zero.

Net Present Value (NPV)The total present value of cash inflows and outflows

Business leaders, financial professionals, and project managers can use NPV to analyze the profitability of a projected investment or project. The investment website Investopedia provides this example of Internal Rate of Return:

Suppose an investor needs $100,000 for a project, and the project is estimated to generate $35,000 in cash flows each year for three years. The IRR is the rate at which those future cash flows can be discounted to equal $100,000.

Remember, “IRR indicates the annualized rate of return for a given investment—no matter how far into the future—and a given expected future cash flow.” The IRR formula is a very common metric for assessing projects and investments.

Internal Rate of Return (IRR) Formula

There are two formulas for calculating the internal rate of return – do not be daunted by the size of them! There are tools and software, such as Microsoft Excel, for calculating the internal rate of return. However, it is critical to know what data to submit into the tool to generate a useable calculation.

IRR Formula Option 1

IRR PMP Formula #1
CF= Cash Flow; n = each period

IRR Formula Option 2

IRR PMP Formula #2
CF = Cash Flow; n = each period; N = holding period

Project managers should be familiar with the IRR formula so that even if software is used for the calculation, stakeholder questions about the method can be addressed.

Internal Rate of Return (IRR) Key Points for Project Management

The IRR is most used in pre-project and project selection for project feasibility studies or in planning studies for large projects. Understanding how IRR relates to project management will help understand PMP exam questions and in practicing project management. Consider these points from Project Engineer saying that the IRR of a project is:

  • the expected growth rate of a project investment.
  • the discount that results in an NPV of zero.
  • being higher indicates a more desirable project.
  • calculated via iterative methods.
  • one metric of several used collectively to justify investing in a project.

The internal rate of return for a large project typically involves a company creating an initial large investment, followed by a steady stream of smaller returns back to the company. IRR, along with ROI and NPV, are tools for measuring the performance of a project investment.

Internal Rate of Return (IRR) Example

The example from Investing Answers.com uses IRR and NPV to help company leaders decide if a project should be approved.

Business Scenario

  • Company X has a year-long project that is going to cost $1,000 and has a discount rate of 8%. At the end of the year, the company will receive $1,300. Calculating the NPV for this project looks like this: 

NPV = -1,000 + 1,3001.08 = 203.70

  • In general, if the NPV is greater than 0, a project is worth pursuing. 
  • The IRR calculation for this same project puts the NPV at 0. When the NPV is 0, it acts as the break-even point. If that’s the case, it will look like this: 

0 = -1,000 + 1,300 (1+IRR)

  • Notice how the discount rate of 8% is replaced with IRR, but the formula remains the same. 
  • Solving for IRR, you will get 0.30 or 30%. 

Review the source of this example for more details: Investing Answers.com

What does this mean for the project? 

Company X can’t forget about their discount rate of 8%, used to calculate the NPV. IRR is compared to the opportunity cost to decide on accepting or declining a project.

As a general rule, if the IRR is higher than the opportunity cost, a company can accept the project or investment. If the project’s “breakeven” return is greater than the company’s opportunity cost, the company could take on this project and increase its value.

What is a “good” IRR and what is a “bad” IRR?

There is not a single value that is a “good” or “bad” IRR. What the IRR indicates about a project investment is shaped by the company’s cost of capital and the industry in which the company operates. A “good” IRR for a construction project for a national company indicating a good project investment may not be the same value for a software start-up. The context of company cash flow, cost of capital, and the industry itself are all key components. Keep in mind these points for when IRR comes out with a positive or negative value:

Positive IRR

  • a project or investment is expected to return value to the organization

Negative IRR

  • can happen if cash flows are alternately positive and negative over the expected duration
  • indicative of a more complicated cash flow stream that may make the metric less useful

In short, IRR estimates the breakeven discount rate (rate of return) and helps a company determine if a project should be pursued or not. If the IRR exceeds the company’s required rate of return, this points to accepting the project. On the other side, if the IRR is below the company’s required rate of return, that points to not accepting the project.

Pros and Cons of IRR

As with any tool, used correctly and with solid data, IRR can be very valuable. If used incorrectly, with faulty data, or interpreted without context, IRR can be harmful.

Advantages of IRR

  • software can do calculations
  • provides a metric to compare to the company’s cost of capital
  • means to garner stakeholder support for a project

Disadvantages of IRR

  • the formula can be daunting and difficult to calculate
  • required data may not be available
  • external factors may impact internal cash flows negating the calculation

Understanding the pros and cons of IRR helps prepare for the PMP exam and for using the tool as a project manager.

IRR and the PMP® Certification Exam

Thinking of the IRR in the PMP exam context and from a project management lens, it is often used for cost-benefit analyses as a success measure suggested by the Project Management Institute (source: PMBOK® Guide, 6th ed., part 1, ch. 1.2.6.4, p. 34). Most likely, IRR PMP exam questions will not require completing the actual calculation but rather an interpretation of a provided IRR value within a given business scenario. Understanding IRR in the PMP exam settings is typically not about math skills but knowing that a high IRR indicates a good project investment. Additionally, it’s important to understand how it relates to Net Present Value.

Example PMP® Certification Exam Questions

QuestionABCD
You are doing some analysis to help with project selection. There is ongoing debate concerning which projects to select. You have the following to choose from: Project A with an IRR of 11.5%, Project B with an IRR of 18%, Project C with an IRR of 15%, and Project D with an IRR of 13%. You can select only one project. Which should you choose?Project AProject BProject CProject D
Your project selection committee is considering four projects. Project A’s NPV is positive, it has an IRR of 14 percent, and the payback period is 21 months. Project B’s NPV is negative, it has an IRR of 9 percent, and the payback period is 16 months. Project C’s NPV is positive, it has an IRR of 16 percent, and the payback period is 18 months. Project D’s NPV is negative, it has an IRR of 16 percent, and the payback period is 13 months. Which project should you choose?Project AProject BProject CProject D

Studying for the PMP Exam?


Answers

  1. B. You always choose the project with the highest internal rate of return (IRR). In this case, you should choose Project B with an IRR of 18%.
  2. C. Payback period is the least precise of all cash flow calculations, so you shouldn’t give this a lot of consideration if NPV is positive and IRR is greater than 0. Since Project B and Project D both have negative NPV, they shouldn’t be chosen. Project C has a higher IRR value than Project A and should be the project you choose.

Conclusion

There may not be a way to 100% of the time completely predict the future, but there are tools available to project managers to ensure data-driven decisions. The Internal Rate of Return is a powerful way to help business leaders and stakeholders understand the financial impact of approving or rejecting one project over another.

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Megan Bell
Megan Bell