How it works
The IRR is the discount rate that makes a project's net present value exactly zero. In symbols, 0 = Σ CF_t / (1 + IRR)^t − I, where CF_t is the net cash flow in year t, t runs from 1 to the project life N, and I is the investment at the start. There is no direct formula once a project has more than a few periods, so it is found by trial. Pick a rate and compute the NPV. Raise the rate if the NPV is positive, lower it if negative, and repeat. Spreadsheet IRR functions do this automatically.
Project IRR uses the cash flows before any financing. The full capital cost goes out and the operating cash flow after tax comes back. Equity IRR uses only the owner's money. The equity contribution goes out and what is left after debt service comes back. Debt is usually cheaper than the project's return, so borrowing lifts the equity IRR above the project IRR. It also makes equity returns swing more in a poor year. A project whose cash flows change sign more than once, for example through a large decommissioning cost at the end, can have two IRRs.
Why it matters
Investors compare the IRR with their hurdle rate, the minimum return they need for the risk they are taking. A developer uses it to decide whether a site is worth building and what price to bid in a tender or accept in a PPA. Sponsors set bids by equity IRR, while lenders focus more on coverage. The measure is sensitive to timing. A six-month delay to commercial operation, or a slow ramp-up, shows in the IRR straight away.
A worked example
A 10 MW solar plant costs $8 million and earns a net cash flow of $1 million a year for 20 years. At a 10% discount rate, the 20-year annuity factor is (1 − 1.10^−20) / 0.10 = 8.514. The NPV is 1 × 8.514 − 8 = +$0.514 million. At 11% the factor is (1 − 1.11^−20) / 0.11 = 7.963, so the NPV is 7.963 − 8 = −$0.037 million. The NPV crosses zero just below 11%, so the IRR is about 10.9%.
Illustrative figures.
Across markets
The calculation is the same everywhere. The return investors will accept differs. Hurdle rates for Indian projects are higher than in the US or Europe, because rupee interest rates and country risk are higher. As an example, Indian equity investors often target returns in the low to mid teens in rupees, while investors in contracted European assets may accept high single digits in euros. Comparisons across markets should state the currency and whether returns are before or after tax.