Internal rate of return, abbreviated as IRR, is utilized when budgeting capital to determine how profitable potential investments will be. Even more so, it is considered a discount rate. This is because it makes the net present value (NPV) equal to zero for all cash flow from a certain project. Furthermore, internal rate of return is calculated in the same manner as the formula for net present value uses.
Here is how to calculate NPV:
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
Therefore, in order to determine what IRR is equal to using the above formula, you would simply set NPV to zero and solve for the discount rate. However, IRR is typically not calculated analytically, but through trial and error or specialized computer programs.
Usually, when a project has a high internal rate of return, it is more desirable to take on the project. Many use the internal rate of return to rank the project opportunities available to make a decision on which is most optimal to take on.
There are instances you may also hear the internal rate of return referred to as the economic rate of return.