What Is Internal Rate of Return (IRR)?

The internal rate of return (IRR) is a financial measure that is used to calculate the profitability of future investments. In a discounted cash flow analysis, the IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero.
IRR is calculated using the same methodology as NPV. Keep in mind that the IRR is not the project’s real cash worth. The yearly return is what brings the NPV to zero.
In general, the greater the internal rate of return, the more appealing an investment becomes. Because IRR is consistent across different types of investments, it may be used to rank numerous potential investments or projects on a level playing field. When comparing investment alternatives with similar features, the investment with the greatest IRR is likely to be the best choice.

IRR stands for the Internal Rate of Return. It is used in financial analysis to evaluate the profitability of potential investments. In simple words, it estimates the return of the investments by considering all the positive and negative cash flows. It is called the Internal Rate of return because no external factors are involved in estimating the business opportunity. IRR is the discounting rate at which the total inflows from a project is equal to the total outflows, where Net Present Value (NPV) is equal to zero.

The purpose of IRR is to identify the rate of discount that converts the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment. Several methods can be used when seeking to identify an expected return. Still, IRR is usually ideal for analysing a new project’s potential return that a business considers to undertake.

For example: An energy company, who has to decide whether to open a new power plant or renovate an old one. Since both the options are adding value to the company we will use IRR to determine which option is more logical and profitable.