Internal rate of return (IRR) is defined as

• A. The discount rate that makes NPV negative
• B. The annual rate of return on the project
• C. The inflation rate used in discounting
• D. The discount rate at which NPV equals zero

Answer: (D)

The rate that makes the net present value of a project’s cash flows equal to zero is the internal rate of return. In other words, IRR is the discount rate at which the present value of inflows equals the present value of outflows, so the overall NPV is zero. This rate can be thought of as the project’s expected annual return implied by its cash flows, assuming you can reinvest at that same rate.

If you discount at a rate higher than the IRR, the NPV will be negative; if you discount at a rate lower than the IRR, the NPV will be positive. It’s not defined by the inflation rate used in discounting, and it’s not simply an accounting measure of return—the IRR reflects the time value of money and the pattern of cash flows to yield a zero NPV.