In one sentenceThe discount rate that makes a project's net present value zero, that is, the annual return the project itself earns on what was invested in it.
Simply put
Instead of choosing a rate and calculating net present value, you look for the rate at which the present value of the cash flows equals the cost. It is found by numerical trial, as the IRR function in Excel does.
The rule: if the rate is higher than the return you require or than your cost of financing, the project is financially acceptable.
Worked example
An investor pays 100,000 SAR into a small project that returns 121,000 SAR to him in one payment after two years, and the return he requires is 8% a year.
Present value at 10% = 121,000 ÷ 1.21100,000 SAR
Net present value = 100,000 − 100,000Zero
Required return8%
Internal rate of return (higher than 8%)10%
Formula: The rate that makes: sum of (cash flow ÷ (1 + rate)^year) − cost = zero
Don't confuse it with
Return on investmentReturn on investment here is 21% for the two years together, and the internal rate of return is 10% a year because it takes timing into account.