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ACCA Applied Knowledge · Management Accounting · Asset budgeting and investment appraisal

Which of the following correctly defines the internal rate of return (IRR) of a project?

IRR is the discount rate that makes a project's net present value equal to zero. At that rate the present value of inflows equals the present value of outflows. A project is acceptable if its IRR exceeds the cost of capital used as the hurdle rate.

  1. AThe discount rate at which the project's net present value is zeroCorrect
  2. BThe average annual accounting profit divided by the average capital invested
  3. CThe rate of return the company's shareholders require on new projects
  4. DThe discount rate at which the project repays its initial outlay within its stated payback period

Explanation

IRR is the discount rate at which the present value of cash inflows equals the present value of cash outflows, so NPV is zero. The accounting rate of return is the average profit divided by the capital invested, which is the second option. The cost of capital is the required return used as the hurdle, not the IRR.

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