IRR is the discount rate that sets the net present value (NPV) of a series of cash flows to zero. In effect, it is the break-even rate of return for the project, given the timing and size of inflows and outflows.
In capital budgeting, IRR helps assess proposed investments by translating a project’s cash flows into a single percentage return. It is typically compared with the company's hurdle rate or cost of capital; if the IRR exceeds that threshold, the project is considered to have a return consistent with the firm's target. The IRR calculation assumes reinvestment of interim cash inflows at the IRR and is sensitive to the timing and magnitude of cash flows.
Some projects with unconventional cash flows can produce multiple IRRs, and ranking projects by IRR can conflict with ranking by net present value when sizes and timing differ. Because IRR does not directly measure risk or value, it is best used alongside other metrics such as NPV and payback period, and in the context of a specific cost of capital and risk assessment.
A company projects an initial outlay of $2 million and a series of cash inflows; solving the IRR gives a result of about 12%, which is then compared to the firm’s hurdle rate.
Net Present Value (NPV) · Discount rate · WACC (Weighted Average Cost of Capital) · Capital budgeting · Hurdle rate · Mutually exclusive projects