The 

internal rate of return is a discount rate that makes the net present value (NPV) of all cash
flows from a particular project equal to zero.” In layman's term, IRR reflects the average annual
return over the lifetime of an investment.

IRR is the rate of interest that makes the sum of all cash flows zero, and is useful to compare
one investment to another. In the above example, if we replace 8% with 13.92%, NPV will
become zero, and that's your IRR. Therefore, IRR is defined as the discount rate at which the
NPV of a project becomes zero.

Profitability of an investment
Corporations use IRR in capital budgeting to compare the profitability of capital projects in
terms of the rate of return. For example, a corporation will compare an investment in a new plant
versus an extension of an existing plant based on the IRR of each project. To maximize returns,
the higher a project's IRR, the more desirable it is to undertake the project. To maximize return,
the project with the highest IRR would be considered the best, and undertaken first.

Maximizing net present value

The internal rate of return is an indicator of the profitability, efficiency, quality, or yield of an
investment. This is in contrast with the net present value, which is an indicator of the net value or
magnitude added by making an investment.

Applying the internal rate of return method to maximize the value of the firm, any investment
would be accepted, if its profitability, as measured by the internal rate of return, is greater than a
minimum acceptable rate of return. The appropriate minimum rate to maximize the value added
to the firm is the cost of capital, i.e. the internal rate of return of a new capital project needs to be
higher than the company's cost of capital. This is because only an investment with an internal
rate of return which exceeds the cost of capital has a positive net present value.

However, the selection of investments may be subject to budget constraints, or there may be
mutually exclusive competing projects, or the capacity or ability to manage more projects may
be practically limited. In the example cited above of a corporation comparing an investment in a
new plant to an extension of an existing plant, there may be reasons the company would not
engage in both projects.
How is IRR used for capital budgeting?
If the same costs apply for different projects, then the project with the highest IRR will be
selected. If an organization needs to choose between multiple investment options wherein the
cost of investment remains constant, then IRR will be used to rank the projects and select the
most profitable one. Ideally, the IRR higher than the cost of capital is selected.

In real life scenarios, since the investment in any project will be huge and will have a long-term
effect, an organization uses a combination of various techniques of capital budgeting like NPV,
IRR and payback period to select the best project.

Illustration

Let us say a company has an option to replace its machinery.

The cost and return are as follows:
Initial investment = Rs.5,00,000
Incremental increase per year = Rs.2,00,000
Replacement value = Rs.45,270
Life of asset = 3 years
If we assume IRR to be 13%, the computation will be as follows.

Year Cash flows Discounted cash flows Computation

0 -5,00,000 -500000 (5,00,000 * 1)
1 2,00,000 176991 2,00,000 * (1/1.13)1
2 2,00,000 156229 2,00,000 * (1/1.13)2
3 2,00,000 138610 2,00,000 * (1/1.13)3
4 45,270 27765 45,270 * (1/1.13)4
The total of the column Discounted Cash Flows approximately sums up to zero making the NPV
equal to Zero. Hence, this discounted rate is the best rate. As can be seen from the above, using
the rate of 13%, the cash flows, both positive and negative become minimum.
Hence, it is the best rate of return on investment. The cost of capital of the company is 10%.
Since the IRR is higher than the cost of capital, the project can be selected.

If the company has another opportunity to invest the money in a project that gives a 12% return,
the company will still go in for the machinery replacement since it gives the highest IRR.

What are the shortcomings of the method?

As mentioned earlier, IRR is widely used and adopted by many companies in combination with
other techniques for capital budgeting. However, this method has some shortcomings.

IRR does not take into consideration the duration of the project.
Example, if the company has to choose between two projects – Project A with IRR 15% and
duration is one year and Project B with IRR 20% and project duration is 5 years and the cost of
capital of the company is 10% – both the projects are profitable. If the company selects Project B
because it has a higher IRR it would be incorrect as the duration of Project B is longer.
IRR assumes that the cash flows are reinvested at the same rate as the project, instead of the cost
of capital. Hence, IRR may not give a true picture of the profitability.
Given the shortcomings of the method, analysts are using the Modified Internal Rate of Return.
It assumes that the positive cash flows are reinvested at the cost of capital and not IRR.

IRR and NPV together can help one understand the profitability of the project and also choose
the most suitable project with a positive NPV. Further, users can compare the IRR of different
projects and go for the most profitable one.