Q. What is internal rate of return (IRR)?
What the Interviewer Want to Know
They want to see that you understand IRR as the discount rate that sets the net present value of all cash flows equal to zero and that you're aware of its role in evaluating the profitability of an investment by accounting for the time value of money, as well as its limitations when comparing projects with varying cash flow patterns.
How to Answer
Internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. It represents the expected annual rate of growth an investment is projected to generate and is commonly used to assess and compare the profitability of potential investments.
Structure it like this:
- Define the concept of IRR.
- Explain how IRR is used to evaluate investment performance.
- Mention its role in comparing profitability among different investment opportunities.
Example Answer
"Internal Rate of Return (IRR) is the discount rate at which the net present value (NPV) of all cash flows from an investment—both incoming and outgoing—becomes zero. In simple terms, it's the annualized rate of return expected from a project or investment, and it helps measure the potential profitability and efficiency of an investment opportunity by comparing this rate with the required rate of return or cost of capital."
Common Mistakes
- Misidentifying IRR as simply a rate of growth rather than the discount rate that sets net present value (NPV) to zero.
- Confusing IRR with other profitability metrics like ROI, without acknowledging its unique time value of money considerations.
- Overlooking the implicit assumptions about reinvestment rates and assuming all intermediate cash flows are reinvested at the IRR, which can be unrealistic.
- Failing to mention the limitations, such as dealing with multiple IRRs in non-conventional cash flows or when cash flows change signs multiple times.
- Not clarifying that IRR is used for project evaluation in capital budgeting, thus missing context about its application and relevance.
- Providing a generic definition without demonstrating an understanding of the mathematical process behind IRR (i.e., solving for the discount rate where NPV equals zero).
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