How do you calculate the internal rate of return (IRR)?

The internal rate of return (IRR) is calculated as the discount rate that makes the net present value (NPV) of all cash flows from a project equal to zero. This concept is critically important in finance because it allows investors and decision-makers to determine the profitability of an investment. In essence, IRR represents the break-even rate of return for a project. If the IRR exceeds the cost of capital, the investment is considered acceptable since it would generate more value than it costs to finance.

By focusing on the point where the NPV equals zero, stakeholders can assess whether the projected returns justify the initial investment and ongoing costs. This method is preferable for evaluating various investment opportunities, as it provides a clear benchmark to compare different projects and helps guide capital allocation.