ACCA Financial Management (F9) Certification Practice Exam

What does the Internal Rate of Return (IRR) determine?

1. The minimum return required to accept a project

2. The exact discount rate that makes NPV zero

3. The average return over the life of the project

4. The total cash inflows over the investment's lifespan

The correct answer is: The exact discount rate that makes NPV zero

The Internal Rate of Return (IRR) is a key metric in capital budgeting and investment analysis, and it specifically refers to the discount rate that results in a net present value (NPV) of zero for a series of cash flows associated with an investment. This concept is crucial for understanding the potential profitability of projects. When calculating IRR, the cash inflows and outflows from an investment are brought to their present values using a discount rate. The specific rate at which the sum of these present values equals zero is what defines the IRR. This means that at this rate, the project is anticipated to break even in terms of value creation, which is essential for decision-making regarding project acceptance or rejection. Other options may seem relevant but do not accurately define IRR. The notion of determining the minimum return required to accept a project is more aligned with the required rate of return or hurdle rate, not IRR itself. The average return over the life of the project could suggest an overall performance measure but does not capture the specific timing and magnitude of cash flows as IRR does. Lastly, the focus on total cash inflows ignores the discounting element that is central to calculating IRR, which relies on the present value of cash flows rather than