What is the internal rate of return (IRR)?

• A. The coupon rate of a bond.
• B. The interest rate that makes the present value of cash flows equal to the investment.
• C. The rate at which taxes are paid on profits.
• D. The rate used to discount inflation.

Answer: (B)

IRR is the discount rate that makes the present value of expected future cash inflows equal to the amount invested, so the net present value is zero. In other words, IRR is the yield the project would generate based on its cash flow pattern when you break even on the initial outlay.

This rate is a handy tool for comparing potential investments. If the IRR is higher than your hurdle rate or cost of capital, the project adds value; if it’s lower, it typically isn’t worth pursuing. Keep in mind a few caveats: with uneven or changing cash flows, you can get multiple IRRs; IRR assumes you can reinvest intermediate cash flows at the IRR, which isn’t always realistic; and IRR doesn’t account for the project’s size or risk level by itself, so it’s best used alongside other measures like NPV and risk assessment.