In the field of finance and investment the internal rate of return (IRR) is defined as the interest rate that gives a net present value (NPV) of zero. The NPV is calculated from an annualized cash flow by discounting all future amounts to the present.
Example: Year Cash flow 0 -100 1 +120
Calculation of NPV: i = interest rate in percent NPV = -100 +120/[(1+i/100)^1]
Calculation of IRR (in percent): NPV = 0 -100 +120/[(1+IRR/100)^1] = 0 IRR = 20%
As an investment decicion tool the calculated IRR is used to rate alternative investments. The investment alternative with the highest IRR is preferred.
Note that placing the initial investment amount in the bank is always an alternative. Thus, any investments which do not match the bank's going deposit rate will not be realized.