The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.

What is Internal Rate of Return Used For?

Companies take on various projects to increase their revenues or cut down costs. A great new business idea may require, for example, investing in the development of a new product. In capital budgeting, senior leaders like to know the reasonably projected returns on such investments. The internal rate of return is one method that allows them to compare and rank projects based on their projected yield. The investment with the highest internal rate of return is usually preferred.

Internal Rate of Return is widely used in analyzing investments for private equity and venture capital, which involves multiple cash investments over the life of a business and a cash flow at the end through an IPO or sale of the business. Thorough investment analysis requires an analyst to examine both the net present value (NPV) and the internal rate of return, along with other indicators, such as the payback period, in order to select the right investment. Since it’s possible for a very small investment to have a very high rate of return, investors and managers sometimes choose a lower percentage return but higher absolute dollar value opportunity. Also, it’s important to have a good understanding of your own risk tolerance, or a company’s investment needs, risk aversion, and other available options.