internal rate of return
The discount rate that makes the net present value of all cash flows from an investment equal to zero — effectively the annualized expected return of an investment.
Example
“The real estate deal had an IRR of 18%, well above the 12% hurdle rate required by the fund.”
Memory Tip
IRR = the true annual return baked INTO the investment. Compare it to your hurdle rate.
Why It Matters
The internal rate of return helps you compare different investments on equal footing by showing the actual annual return you can expect. Understanding IRR allows you to make better decisions about where to put your money, whether in stocks, bonds, real estate, or business ventures, by comparing the true earning potential of each option.
Common Misconception
Many people confuse IRR with the simple average return or assume it is the same as the stated interest rate on an investment. In reality, IRR accounts for the timing and size of each cash flow, so an investment with irregular payments or multiple years of returns will have an IRR that differs significantly from just dividing total gains by the number of years.
In Practice
Suppose you invest 10,000 dollars in a project that returns 3,000 dollars in year one, 5,000 dollars in year two, and 6,000 dollars in year three. The internal rate of return is approximately 11.6 percent annually, meaning if you discount all future cash flows at 11.6 percent, they sum to exactly zero relative to your initial investment, showing you the true annualized gain of the project.
Etymology
INTERNAL (inherent to the investment itself) RATE OF RETURN (percentage gain). The rate the investment INTERNALLY generates.
Common Misspellings
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See Also
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