IRR, or Internal Rate of Return, is a special application of the logic behind NPV, or Net Present Value calculations. It is a commonly-used concept in project and investment analysis, including capital budgeting.
The IRR of a project or investment is the discount rate that results in an NPV of zero. If the actual discount rate (which is the theoretic cost of funds to the company or investor in question) is lower than the IRR, the project or investment should be undertaken.
Limitations of IRR Analysis:
Projected or forecasted returns may not materialize as anticipated.
A project or investment with a lower anticipated IRR may be preferable if that lower IRR can be earned on a larger principal amount. For example, on opportunity to earn 30% on a $100,000 investment brings greater absolute rewards than 40% on $1,000.
A project or investment with a lower anticipated IRR may be preferable if that lower IRR can be earned for a longer period of time. For example, earning a compounded 30% over four years, which nearly triples your investment, arguably is a better alternative than earning 40% for just one year and having highly uncertain prospects for reinvestment thereafter.
The overall IRR of an investment portfolio is not the average of the IRRs on each project, security or investment therein. Rather, the overall IRR of a portfolio with high initial returns of capital typically is greater than the overall IRR of a portfolio in which most gains come later, even if the latter has greater total gains over time. Thus, private equity managers often seek to produce a higher IRR on an investment portfolio by cashing out winning investments early while keeping losing investments longer.
For limitations of IRR analysis, see "To rate a return, think of what you're missing" by John Kay, Financial Times, 9/8/2010.
In the example given in the glossary entry for NPV, the IRR would be just over .1518, or 15.18%.