Short answer: Internal rate of return, or IRR, is the discount rate at which the net present value of all cash flows from an investment comes to zero. It can also be read as the estimated compounded annual growth rate of an investment’s cost. A higher IRR indicates better profitability, which is why analysts use it to compare investments.
Last reviewed: 9 November 2026
At a glance
| Term | What it means |
|---|---|
| Net present value (NPV) | The total of all cash flows, inflows and outflows together, brought to a single value |
| IRR | The discount rate at which NPV comes to zero |
| Compounded growth reading | IRR read as the estimated compounded annual growth rate of an investment’s cost |
| How IRR is found | Trial and error, testing discount rates until NPV is close to zero |
| Tools | Microsoft Excel or a financial calculator |
| Higher IRR | Indicates better profitability; used to rank competing investments of similar size |
What does IRR measure in an investment?
An investment usually involves money going out at the start and money coming back later. Each of these payments is a cash flow, and outflows are counted as negative while inflows are counted as positive. A discount rate is the rate used to convert rupees received in the future into their equivalent value today.
Net present value, or NPV, is what you get when every cash flow is converted this way and added together. IRR is the particular discount rate that makes this total exactly zero. In other words, it is the rate at which the money coming in just pays back the money going out, with the time value of money built in.
How does IRR work with a simple example?
The following is a hypothetical example with invented figures, used only to show the arithmetic. Suppose you pay ₹1,00,000 today for a project that returns ₹1,10,000 after one year. The cash flows are −₹1,00,000 today and +₹1,10,000 at the end of year one.
Test a discount rate of 10%. Dividing ₹1,10,000 by 1.10 gives ₹1,00,000, so the NPV is −₹1,00,000 + ₹1,00,000 = ₹0. The IRR is therefore 10%.
Now test 12%. Dividing ₹1,10,000 by 1.12 gives about ₹98,214, so the NPV is about −₹1,786. Because the NPV is negative at 12%, the IRR must be lower than 12%, which matches the 10% found earlier.
Why is IRR found by trial and error?
There is no direct algebraic formula that solves for IRR when a project has several cash flows over several years. Instead, analysts test different discount rates and check whether the NPV is close to zero. They keep adjusting the rate until the NPV is near zero, and the rate they land on is the IRR.
Few people do this by hand. Spreadsheet software such as Microsoft Excel, or a financial calculator, is commonly used to compute IRR for a series of cash flows. The result is only as reliable as the cash flows entered, so the input figures matter as much as the calculation.
Why is a higher IRR used to rank investments?
A higher IRR indicates better profitability, so IRR is used to rank competing projects or investments of similar size. A project with a 20% IRR is, on this measure, ahead of one with a 12% IRR when both cost roughly the same.
The catch is that IRR measures the rate, not the total rupees earned. The following is another hypothetical example. Project A costs ₹1 lakh and returns ₹1.3 lakh after one year, giving an IRR of 30% and a profit of ₹30,000. Project B costs ₹10 lakh and returns ₹11.5 lakh after one year, giving an IRR of 15% and a profit of ₹1.5 lakh.
Project A has the higher IRR, but Project B earns ₹1.2 lakh more in rupees. This is why IRR is most useful when the projects being compared are of similar size.
What are the limits of IRR?
IRR depends entirely on the cash flows fed into it. If the expected inflows are optimistic, the IRR will look better than the project may deliver, so an IRR is only as good as its estimates. It is a calculated figure based on projected cash flows, not a guaranteed return.
IRR also says nothing about the size of an investment. As the hypothetical lakh-versus-crore comparison above shows, a small project with a high IRR can add fewer rupees than a large project with a lower one. Checking the NPV and the total rupee gain alongside the IRR gives a fuller picture.
Finally, the compounded growth reading is an estimate. It describes what the cost of an investment would need to grow at each year to match the cash flows, and it does not promise that growth will happen.
Frequently asked questions
Is IRR the same as an interest rate?
No. IRR is the discount rate at which the NPV of an investment’s cash flows is zero. It is a result calculated from those cash flows, not a rate fixed by a lender or bank.
How is IRR calculated?
There is no direct formula, so IRR is found by trial and error, testing discount rates until the NPV is close to zero. Analysts commonly use Microsoft Excel or a financial calculator for this.
Is a project with a higher IRR always the better choice?
A higher IRR indicates better profitability, and IRR is used to rank competing investments of similar size. For investments of very different sizes, the IRR alone does not show the total rupee gain.
Sources and last check
Facts in this article were checked against the sources below on 9 November 2026. Rules and figures can change; check the primary source before acting.
- groww.in (broker education)
- dhan.co (broker education)
- icicidirect.com (broker education)
This article is general information, not investment advice. MyFinanceBandhu is not a SEBI-registered investment adviser.