Definition
Internal Rate of Return (IRR)
The discount rate at which an investment's net present value (NPV) equals zero, representing the investment's expected annualized rate of return. Accept the investment if IRR exceeds the required rate of return (the hurdle rate); reject it if IRR falls below the hurdle rate. For bonds, IRR is equivalent to yield to maturity (YTM). IRR works best for investments with predictable cash flows and a known end date, such as bonds or direct participation programs; it is impractical for common stock, which has unpredictable dividends and no maturity date.
A bond has an IRR of 7%, and the investor's required rate of return is 8%. Because the IRR falls below the hurdle rate, the bond does not meet the investor's minimum return requirement and should be rejected, even though it still produces a positive return in absolute terms.
IRR assumes interim cash flows are reinvested at the IRR itself, which is often unrealistic when the IRR is unusually high. NPV assumes reinvestment at the more conservative discount rate instead, which is why NPV, not IRR, is the preferred method when the two disagree on mutually exclusive projects. Also easy to miss: IRR is expressed as a percentage, while NPV is expressed in dollars.
How is Internal Rate of Return (IRR) tested on the exam?
- Comparing a given IRR to a hurdle rate to determine the accept/reject decision
- Identifying IRR as the rate at which NPV equals zero
- Recognizing that IRR equals yield to maturity (YTM) for bond investments
- Identifying which investment types IRR is and is not practical for (bonds and DPPs versus common stock)
- Explaining why NPV is preferred over IRR when the two methods conflict on mutually exclusive projects
Calculation example
Calculation Example
Decision rule: Accept if IRR > hurdle rate; Reject if IRR < hurdle rate - Identify the IRR: 9%
- Identify the hurdle rate (required rate of return): 7%
- Compare the two: 9% is greater than 7%, so the IRR exceeds the hurdle rate
- Because IRR exceeds the required return, the investment's NPV, if calculated at the 7% hurdle rate, would be positive
IRR is the exact height of hurdle an investment can clear: its rate is compared directly against your required "hurdle rate." Clear the hurdle (IRR above the required return) and accept; clip it (IRR below) and reject.
Practice questions
Test your understanding with the questions below. Pick an answer to reveal the explanation.
A financial adviser is evaluating a corporate bond for a client whose required rate of return is 6%. The bond's internal rate of return is calculated at 5.25%. What should the adviser recommend?
B is correct. The bond's IRR (5.25%) is below the client's 6% required rate of return (hurdle rate), so the investment does not meet the minimum return the client needs. The IRR decision rule calls for rejection whenever IRR falls short of the hurdle rate.
A is incorrect because a positive IRR alone doesn't satisfy the decision rule; it must also exceed the hurdle rate. C is a false generalization: bonds are well suited to IRR analysis, but that doesn't mean every bond automatically passes the decision rule. D is incorrect; an IRR below the hurdle rate implies a negative NPV at that hurdle rate, not an incalculable one.
The Series 65 exam regularly pairs a given IRR with a required rate of return and expects you to apply the accept/reject rule correctly, not just recognize whether the IRR is a positive number.
The internal rate of return (IRR) is best defined as:
A is correct. IRR is defined as the discount rate that makes an investment's NPV equal to zero, representing its expected annualized rate of return.
B describes the coupon rate, a fixed, stated figure unrelated to IRR. C describes a simple average return, not IRR, which accounts for the timing of cash flows. D describes trading at par, an unrelated bond-pricing concept.
Confusing IRR with a bond's coupon rate is a common error. The coupon rate is fixed at issuance; IRR reflects the actual return based on cash flows and price paid, and moves with market conditions.
An investment's cash flows produce an internal rate of return of 9%. The investor's required rate of return (hurdle rate) is 7%. Based on the IRR decision rule, what should the investor do, and what does this imply about the investment's NPV at the 7% hurdle rate?
A is correct. Since the IRR (9%) exceeds the hurdle rate (7%), the decision rule calls for acceptance. Whenever IRR exceeds the discount rate used, the resulting NPV at that discount rate is positive, since IRR is by definition the rate at which NPV would equal exactly zero.
B, C, and D each pair the wrong decision with the wrong NPV sign; an IRR above the hurdle rate can only correspond to a positive NPV at that hurdle rate, and always calls for acceptance, never rejection.
The Series 65 exam often tests IRR and NPV together instead of in isolation. Understanding that an IRR above the hurdle rate always implies a positive NPV at that same rate (and vice versa) is a shortcut that saves time on exam day.
All of the following statements about internal rate of return (IRR) are accurate EXCEPT
C is correct (the EXCEPT answer). IRR assumes interim cash flows are reinvested at the IRR itself, not at the discount rate. Assuming reinvestment at the discount rate is NPV's assumption, not IRR's, and is one reason NPV is considered more realistic.
A is accurate: IRR is a percentage. B is accurate: for bonds, IRR and YTM are the same measure. D is accurate: common stock's unpredictable dividends and lack of a maturity date make IRR impractical, unlike bonds or DPPs.
Swapping NPV's and IRR's reinvestment assumptions is one of the most common wrong-answer traps on this topic. Knowing that IRR reinvests at the IRR itself, and why that's less realistic, is frequently tested.
Which of the following statements about internal rate of return (IRR) are accurate?
1. IRR is the discount rate at which NPV equals zero
2. IRR is well suited to evaluating a zero-coupon bond
3. IRR is well suited to evaluating common stock with variable dividends
4. When NPV and IRR conflict on mutually exclusive projects, IRR is the preferred method
A is correct. Statements 1 and 2 are accurate.
Statement 1 is TRUE: IRR is defined as the discount rate that sets NPV to zero. Statement 2 is TRUE: zero-coupon bonds have no interim cash flows to reinvest, which removes the reinvestment-rate uncertainty and makes IRR especially straightforward to apply. Statement 3 is FALSE: common stock's unpredictable dividends and lack of a maturity date make IRR impractical. Statement 4 is FALSE: NPV, not IRR, is the preferred method when the two conflict on mutually exclusive projects.
This question combines several commonly tested IRR facts (its definition, which investments it suits, and the NPV-versus-IRR tiebreaker) into one question, which mirrors how the Series 65 exam frequently layers related concepts.
Where does Internal Rate of Return (IRR) appear on the Series 65 exam?
This term is tested in the following Series 65 exam topics: