Internal rate of return (IRR)

Definition

Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It is used to evaluate the profitability of potential investments.

5 Must Know Facts For Your Next Test

1. IRR is found by solving for the discount rate that sets the NPV of cash flows to zero.
2. A project is generally considered acceptable if its IRR exceeds the required rate of return.
3. IRR assumes that intermediate cash flows are reinvested at the same rate as the IRR itself, which may not always be realistic.
4. IRR can be calculated using financial calculators or spreadsheet software like Excel.
5. Multiple IRRs can exist if a project has alternating positive and negative cash flows.

Review Questions

• What does it mean when a project's IRR is higher than the required rate of return?
• How does IRR treat intermediate cash flows in terms of reinvestment?
• Why might a project have multiple IRRs?

Related terms

Net Present Value (NPV):

The difference between the present value of cash inflows and outflows over a period.

Discount Rate:

The interest rate used to discount future cash flows back to their present value.

Profitability Index (PI): A ratio that calculates the relative profitability of an investment by dividing its benefits by its costs.