Internal rate of return
The internal rate of return is the discount rate at which an investment's net present value equals zero.
Instead of asking how much value a project creates, you can ask what return it earns. That return, the internal rate of return, is intuitive, popular, and quietly treacherous.
The internal rate of return is the discount rate at which an investment's net present value equals zero, in effect the rate of return the investment is expected to earn. It is a widely used measure of an investment's profitability, attractive because it expresses the result as a single percentage that can be compared with the cost of capital.
The break-even discount rate
The internal rate of return is found by asking what discount rate would make the present value of a project's future cash flows exactly equal to its cost, so that net present value is zero. That rate is the project's implied return. The decision rule is to accept a project if its internal rate of return exceeds the cost of capital, the minimum return required, and reject it otherwise, since a return above the cost of capital means the project earns more than the funds used to finance it cost.
Why it appeals
The internal rate of return is popular because it is intuitive: a single percentage that seems to answer the natural question, what return does this earn, and that can be compared directly with required returns and other investments without needing a discount rate to be specified in advance. Managers and investors find a rate of return easier to grasp and communicate than an absolute sum of value, which is part of why the measure is so widely used despite its flaws.
The traps
The internal rate of return has well-known pitfalls. It can give misleading rankings between projects of different sizes or timing, favouring a high-percentage return on a small project over a larger absolute gain. Projects with unconventional cash flows, where outflows follow inflows, can have multiple internal rates of return or none. And it implicitly assumes interim cash flows are reinvested at the internal rate itself, which is often unrealistic. For these reasons, finance theory regards net present value as the sounder measure where the two conflict.
The internal rate of return is among the most used and most misused tools in finance, prized for the intuitive appeal of a single percentage and dangerous for the traps that percentage conceals. It is a useful complement to net present value, but where they disagree, especially in ranking projects, the discipline of net present value should prevail, because the seductive simplicity of a return figure can lead to choices that create less value than the alternatives.