Corporate finance

What is internal rate of return?

IRR is the discount rate at which cash flows have zero net present value.

Definition

IRR is the discount rate at which cash flows have zero net present value.

Intuition

It summarizes a cash-flow series as an annualized break-even rate.

Formula

0 = \sum_{t = 0}^{N} \frac{{CF}_{t}}{{(1 + IRR)}^{t}}

IRR is the discount rate that makes the net present value of all cash flows equal zero.

Example

Enter an initial investment of 1,000 as the time-zero outflow.
Enter inflows of 600 in year one and year two.
IRR is about 13.07%, the rate at which these cash flows have an NPV near zero.

Common mistakes

Do not overlook multiple roots or directly compare investments of very different sizes by IRR alone.