The internal rate of return (IRR) or yield can be defined as the discount rate, which equates the present value of the expected initial cash investment with the present value of the expected cash inflows. In other words, the IRR is the discount rate that, when applied to an investment’s cash flows, gives a net present value of zero. The IRR is, in effect, an investment project’s expected rate of return, E(r), and it may, of course, be greater than, equal to, or less than a project’s required rate of return, R(r).
In applying IRR, the decision rule is: “If the IRR is greater than, or equal to, the required rate of return the project is considered acceptable; if the IRR is less than the required rate of return, the project is not considered acceptable.” The IRR is more difficult to calculate manually than NPV. It has to be determined by iteration or trial-and-error techniques and the application of some common sense. This is facilitated by financial calculators and computer software. The intermediate value of IRR can be found using the formula:
where r1 is lower discount rate, r2 is the higher discount rate, NPV1 is the NPV of the cash flows at r1, and NPV2 is the NPV of the cash flows at r2 %.