What is Internal Rate of Return (IRR) and its decision rule?

• A. IRR is the discount rate that makes NPV positive.
• B. IRR is the average return on investment.
• C. IRR is the discount rate that makes NPV zero; accept if IRR ≥ required rate of return.
• D. IRR measures payback period.

Answer: (C)

Internal rate of return is the discount rate that makes the net present value of a project’s cash inflows and outflows equal to zero. It represents the project’s yield—the rate of return you’d effectively earn on the investment when you bring all cash flows to present value.

The decision rule is straightforward: accept the project if the IRR is at least the required rate of return (the hurdle rate), and reject if it’s below. This works because a project whose IRR meets or exceeds the hurdle rate should add value by earning a return that covers the minimum acceptable cost of capital.

Why the other ideas don’t fit: the IRR is not the discount rate that makes NPV positive (that would imply a threshold where NPV is above zero, not the zero point itself). It’s not simply the average return on the investment, since IRR accounts for the timing and magnitude of all cash flows. And it isn’t a measure of the payback period, which only tells how long it takes to recover the initial investment, ignoring cash flows after payback and time value of money.