Which statement defines internal rate of return (IRR) as used in capital budgeting?

• A. Internal rate of return is the discount rate that makes net present value zero.
• B. IRR is the average annual rate of return on an investment.
• C. IRR is the ratio of net income to total assets.
• D. IRR is the maximum loan interest rate.

Answer: (A)

Internal rate of return is the discount rate that makes the project’s net present value equal to zero. In other words, it’s the rate of return implied by the series of cash flows the project generates, taking into account the time value of money. You find it by solving NPV = 0 for the discount rate, using the initial investment as a negative cash flow and the future cash inflows as positive flows.

This rate is used to decide whether to pursue a project: if the IRR is higher than your required return or the company’s cost of capital, the investment adds value and is attractive. If the IRR is below the hurdle rate, it’s typically rejected. Be mindful that IRR assumes that intermediate cash inflows are reinvested at the IRR, which can be a limitation, and for some cash-flow patterns there may be multiple IRRs.

For comparison, the other statements describe different concepts: an average annual return ignores the time value of money, a return on assets is a ratio of net income to assets, and a maximum loan rate is unrelated to the project’s internal rate of return.