What is the internal rate of return?

The internal rate of return (IRR) is defined as the interest rate that makes the net present value (NPV) of all cash flows from a particular investment equal to zero. This concept is crucial in capital budgeting, as it allows investors and managers to evaluate the profitability of an investment. When calculating IRR, an investor is essentially trying to determine the rate at which the present value of the expected cash inflows equals the present value of the cash outflows associated with the investment.

When the IRR is higher than the required rate of return or the cost of capital, it often indicates a worthwhile investment opportunity because it implies that the investment will generate more returns than costs when discounted back to present value. Conversely, if the IRR is below the required rate of return, it may suggest that the investment is not favorable.

This understanding of IRR as the interest rate that results in an NPV of zero is fundamental to making informed financial decisions regarding investments and project evaluations.