What is the IRR in capital budgeting?

The internal rate of return (IRR) is a critical concept in capital budgeting. It refers to the discount rate at which the net present value (NPV) of all cash flows from a particular project equals zero. In simpler terms, this means that the IRR is the rate that makes the present value of expected cash inflows from a project equal to its initial outflows (or costs).

When evaluating investment opportunities, the IRR serves as a benchmark for decision-making. If the IRR of a project exceeds the required rate of return or cost of capital, it suggests that the project is likely to add value and should be considered for acceptance. Conversely, if the IRR is lower than the required rate, the project may not be worth pursuing.

This understanding of IRR simplifies the decision-making process for managers and investors, allowing them to compare different projects and make informed choices based on the projected returns relative to costs. It encapsulates the efficiency of an investment in generating returns and is a fundamental metric in capital budgeting analyses.