The Internal Rate of Return measures the expected annual return from a project, representing the discount rate at which the project breaks even in net present value terms.
Project IRR is the discount rate that makes the net present value of all cash flows from a project equal to zero. It represents the expected compound annual return from investing in the project based on projected cash flows.
Project IRR tells you what return the project is expected to generate annually. If a project has an IRR of twenty percent and your cost of capital is twelve percent, the project is expected to generate returns above your required threshold.
A real estate project requires ₹100 crore investment and generates ₹25 crore annually for six years plus ₹20 crore from sale at the end. The IRR calculates what return rate those cash flows represent. If it is twenty percent, the project returns twenty percent annually.
Initial investment: ₹100 crore. Year 1-5 cash flows: ₹20 crore each. Year 6 cash flow: ₹20 crore plus sale proceeds ₹30 crore equals ₹50 crore. Total inflows: ₹150 crore on ₹100 crore investment over six years. IRR calculates the rate at which NPV equals zero.
Project IRR is only as reliable as the cash flow projections. Optimistic projections produce optimistic IRRs. Sensitivity analysis around key assumptions—occupancy rates, sale prices, construction costs—reveals how robust the return is.
Project IRR should be compared to the cost of capital, required return thresholds, and alternative investment opportunities. Projects with IRR significantly above the hurdle rate provide margin of safety; those close to the hurdle rate require scrutiny.