How is the internal rate of return (IRR) determined?

The internal rate of return (IRR) is determined as the discount rate that equates the net present value (NPV) of all cash inflows and outflows of a project to zero. This means that at the IRR, the present values of the expected cash inflows from the investment will exactly offset the initial investment cost. The IRR is a critical metric used in capital budgeting to evaluate the attractiveness of an investment or project; a higher IRR suggests a potentially more profitable investment.

In practical terms, when performing an investment appraisal, if the IRR is greater than the required rate of return or the cost of capital, the investment is considered favorable. This approach allows companies to compare the profitability of different investments on a consistent basis, as IRR provides a single percentage figure that indicates the expected return.

Understanding that IRR represents the break-even point where the NPV transition from positive to negative is fundamental in financial decision-making, enabling organizations to make informed choices about which projects or investments to pursue.