Internal Rate of Return (IRR) answers a simple question: at what discount rate does a project exactly break even on a present-value basis? It is the rate that makes the Net Present Value (NPV) equal to zero. If this rate exceeds your cost of capital (hurdle rate), the project creates value — accept it. If it falls below, reject it.
Think of it this way: Mr. Sharma's factory project promises ₹50,000 cash inflows every year for 5 years on an investment of ₹1,50,000 today. The bank charges 12% on funds. If the project's IRR works out to 18%, the project earns more than it costs — green light. If IRR is 9%, the project doesn't even cover borrowing costs — red light. This is why IRR is so popular with CFOs: it gives a single percentage you can compare directly to a borrowing rate or a benchmark return.
Because IRR has no closed-form formula, you calculate it by interpolation (trial and error). The exam-standard method: pick two discount rates — one giving a positive NPV (rate too low) and one giving a negative NPV (rate too high). Then use the formula: IRR = Lower Rate + [NPV at Lower Rate ÷ (NPV at Lower Rate − NPV at Higher Rate)] × (Higher Rate − Lower Rate). The closer your two trial rates bracket the true IRR, the more accurate your answer. ICAI typically awards marks even for a slightly off answer if the working is correct, so always show both trial NPVs.
Key limitations the examiner loves to test: (1) IRR assumes cash inflows are reinvested at the IRR itself — which is often unrealistic; NPV's reinvestment assumption (at cost of capital) is more conservative and reliable. (2) With non-conventional cash flows (sign changes mid-project), you can get multiple IRRs — the method breaks down. (3) For mutually exclusive projects, IRR can mislead if project sizes differ; always cross-check with NPV. This is asked frequently as a 4–6 mark theory or numerical question, especially in combination with NPV comparison.