The IRR is the return rate the project earns on the investment. It measures (on a percentage basis) how much money the project makes respect to its initial investment. The IRR is calculated as the rate at which the PV of the Cash Flow equals the initial investment. The underlying concept here is very simple: we want to calculate a rate that would make the future cash flow equivalent to the investment, so that it can be said say that they both are worth the same (on present terms).

Since the IRR makes the PV of the cash flow the same as the investment, the NPV of any project when calculated at its IRR is zero. So, mathematically the IRR is defined as the discount rate that makes the NPV zero. For this reason the IRR can only be calculated by an iterative, trial and error process, that tracks the variations on the project NPV for different rates of return until the rate at which NPV=0 is reached. This rate is said to be the IRR.

When all negative cash flows occur earlier in the sequence than all positive cash flows, or when a project's sequence of cash flows contains only one negative cash flow, IRR returns a unique value. Most capital investment projects begin with a large negative cash flow (the up-front investment) followed by a sequence of positive cash flows, and, therefore, have a unique IRR. However, sometimes there can be more than one acceptable IRR, or sometimes none at all.

NPV determines whether a project earns more or less than a desired rate of return (also called the hurdle rate) and is good at finding out whether or not a project is going to be profitable. IRR goes one step further than NPV to determine a specific rate of return for a project. Both NPV and IRR give you numbers that you can use to compare competing projects and make the best choice for your business.

It is well known that the IRR should not be used to select among different investment alternatives, but only to decide whether a single project is worth investing in. The issue when comparing mutually exclusive investments is that sometimes a project with a higher IRR might have a lower NPV leading to an incorrect investment decision.

Similarly, the IRR should not be used for projects that start with positive cash inflow at the year zero, nor projects with multiple sign changes in its cash flow, as they might have multiple IRRs making the decision rules inappropriate.

A critical deficiency of the IRR is that it is commonly misunderstood to convey the actual annual profitability of an investment. In reality, the IRR measures the rate of return of the investment that has not been recovered yet, i.e. the part that still remains “internally” in the project every period.

This book contains several examples sowing how to evaluate whether or not the IRR should be used for each type of project.

You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.