What is the internal rate of return (IRR)?

The internal rate of return (IRR) is defined as the discount rate that causes the net present value (NPV) of all cash flows from a particular investment to equal zero. In other words, IRR is the rate at which the present value of expected future cash flows matches the initial investment. This concept is crucial in capital budgeting because it helps investors determine whether a particular investment is likely to yield returns above a specified threshold, often compared to the hurdle rate or required rate of return.

The higher the IRR relative to the cost of capital, the more attractive the investment. If the IRR exceeds the required rate of return, then the project is generally considered a good investment. This ability to simplify the decision-making process regarding investment is why the IRR is a critical metric in finance and investment analysis.