FinLyneDefinition
IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
Explanation
IRR is used in capital budgeting to evaluate the profitability of potential investments. A project is considered attractive if its IRR exceeds the required rate of return. Unlike NPV, IRR expresses returns as a percentage, making it intuitive for comparing projects of different scales. However, it assumes reinvestment at the IRR itself, which can be unrealistic for high-return projects.
Example
An investor puts $100,000 into a project. Year 1 returns $40,000, Year 2 returns $50,000, Year 3 returns $45,000. The IRR — the rate that zeroes out the NPV — is approximately 18.7%. Since this exceeds their 12% hurdle rate, the investment is deemed worthwhile.