The internal rate of return, or IRR, is the discount rate at which the net present value of an investment's cash flows equals zero. It represents the annualised effective return the investment is expected to generate over its life. A project is generally worth pursuing when its IRR exceeds the required rate of return, or hurdle rate.
Worked example
An investment costs $1,000 today and pays $1,210 in two years. The IRR is the rate r where $1,210 ÷ (1 + r)² = $1,000. Solving, (1 + r)² = 1,210 ÷ 1,000 = 1.21, so 1 + r = 1.10 and r = 10%. The investment's IRR is 10%.
Why it matters
IRR is popular because it expresses an investment's return as a single percentage that is easy to compare against a hurdle rate. The main pitfall is that IRR can be misleading for projects with unconventional cash flows, where multiple IRRs are possible, and it implicitly assumes interim cash flows are reinvested at the IRR itself, which is often unrealistic. For ranking projects, NPV is usually the safer guide.
Frequently asked questions
An IRR is "good" when it comfortably exceeds the required rate of return or cost of capital for the investment. There is no universal threshold, since acceptable IRRs depend on the risk and the available alternatives.
They can rank projects differently because IRR assumes reinvestment at the IRR while NPV assumes reinvestment at the discount rate. When they conflict on mutually exclusive projects, NPV is generally the more reliable criterion.