What Is the Internal Rate of Return (IRR)?
The internal rate of return is the discount rate at which a project's net present value is zero. A project is acceptable if its IRR exceeds the cost of capital. Here's how it works.
The internal rate of return (IRR) is the discount rate at which a project's net present value (NPV) is exactly zero. Put another way, it's the effective return a project is expected to generate. The decision rule is simple: accept a project if its IRR exceeds the company's cost of capital, and reject it if the IRR is lower.
How is IRR calculated?
In exams, IRR is usually estimated using linear interpolation:
- Calculate the NPV at a low discount rate (aim for a positive NPV).
- Calculate the NPV at a higher discount rate (aim for a negative NPV).
- Interpolate between the two rates to estimate where NPV equals zero.
Choosing rates that give one positive and one negative NPV keeps the estimate reasonable.
IRR versus NPV
IRR is intuitive — it's a percentage return — but it has drawbacks: it can give multiple answers with unconventional cash flows, and it can rank mutually exclusive projects wrongly. NPV is generally regarded as the more reliable method because it measures the absolute change in shareholder wealth.
IRR in ACCA FM
FM frequently asks for IRR by interpolation and a comparison with NPV. The marks come from a clean layout, sensible chosen rates and correct interpolation. Practising full appraisal questions and marking them against the official ACCA scheme with The 50% Club shows you exactly where your method slips — the quickest way to secure these marks.