What is Internal Rate of Return (IRR)?
Internal Rate of Return (IRR) is the discount rate that makes Net Present Value (NPV) equal to zero. It represents the average annual return an investment generates and is used to compare projects regardless of size or timing.
IRR is the discount rate where NPV = 0. It's the break-even return rate. Compare projects: choose the one with the highest IRR, or accept if IRR exceeds the required return (discount rate / hurdle rate).
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Step-by-step worked examples
A project costs $100,000, generates $30,000/year for 5 years. Estimate IRR.
Total cash inflow = $150,000 Approximate IRR = ((150,000 / 100,000)^(1/5) − 1) × 100 = (1.5^0.2 − 1) × 100 = (1.084 − 1) × 100 = 8.4% This is the breakeven rate; if required return is 8%, accept the project.
Compare two projects: A generates 15% IRR, B generates 12% IRR, both have positive NPV. Which to choose?
Project A (15% IRR) is better if both investments are the same size and risk profile. However, if capital is limited, also check NPV and profitability index. The higher IRR signals higher return per dollar invested.
Your company's hurdle rate is 10%. Project has 12% IRR. Recommendation?
Accept the project. IRR (12%) > Hurdle Rate (10%), meaning the project's return exceeds the required rate. This project adds value.
Flashcards
Quick quiz
Q1.A project has IRR = 9%, and the company's hurdle rate is 12%. Decision?
Q2.Which is correct: IRR is the rate where…
Q3.Project A: IRR = 20%, Project B: IRR = 15%. Both have positive NPV. Best choice?
Q4.IRR assumes cash flows are…
The full card deck, worked steps and AI-tutor support for “What is Internal Rate of Return (IRR)?” are in Notek — study by hand before your exam.
Common mistakes
Higher IRR always means higher profit in absolute dollars. — Correct: Higher IRR means higher percentage return, but NPV (dollars) depends on project size and duration.
IRR and NPV always agree on which project to choose. — Correct: They can conflict when projects differ in size or timing. NPV is preferred for final decision.
IRR can be calculated easily for all projects. — Correct: Some projects have multiple IRRs (unusual cash flows) or no real IRR. NPV is more robust.
A negative IRR means the project loses money immediately. — Correct: Negative IRR means total cash flows never break even — over the project's life, you lose money.
FAQ
What is IRR and how is it used?
IRR is the percentage return a project generates. Accept if IRR > your hurdle rate (required return), because then the project earns more than your cost of capital.
IRR vs Payback Period: which is better?
IRR is better because it accounts for time value of money and all cash flows. Payback period only shows recovery time, ignoring returns after payback.
Can you have multiple IRRs for one project?
Yes, if cash flows are unusual (e.g., big outflow mid-project). In such cases, NPV is more reliable.
Does IRR consider reinvestment of cash flows?
Yes—it assumes intermediate cash flows are reinvested at the IRR rate. In reality, they may earn a different rate.