The internal rate of return is the interest rate that will discount an investment's future cash amounts so that the sum of the present values will be equal to cash paid at the beginning of the investment. In capital budgeting, the internal rate of return is also the interest rate that results in an investment having a net present value of zero.
To illustrate, let's assume that a company is considering an investment that will provide net cash inflows of $1,000 at the end of each year for five years. The amount of cash that the company must pay at the beginning of the investment is $3,600. Someone will need to compute the interest rate that will discount the five $1,000 future cash receipts so that their present value at the time of the investment will equal $3,600. Through software or through trial and error, you will find that the internal rate of return on this investment is approximately 12%.
The internal rate of return is one of the tools in capital budgeting that considers the time value of money and also considers all of the cash payments and cash receipts during the life of an investment.