What is the internal rate of return decision rule in capital budgeting?

The internal rate of return (IRR) decision rule in capital budgeting is a method used to evaluate the profitability of an investment project. It is the discount rate at which the net present value (NPV) of the project becomes zero.

The IRR decision rule states that if the IRR of a project is greater than the required rate of return or the cost of capital, then the project is considered acceptable or profitable. On the other hand, if the IRR is less than the required rate of return, the project is deemed unprofitable and should be rejected.

In simpler terms, the IRR decision rule helps in determining whether an investment project will generate a return that is higher than the cost of capital. If the IRR is higher, it indicates that the project is expected to generate a positive return and is therefore worth pursuing. Conversely, if the IRR is lower, it suggests that the project is not expected to generate sufficient returns and should be rejected.

The IRR decision rule is a widely used technique in capital budgeting as it provides a clear benchmark for evaluating the profitability of investment projects. However, it is important to note that the IRR decision rule has certain limitations, such as potential conflicts with mutually exclusive projects and the assumption of reinvesting cash flows at the IRR itself. Therefore, it is often used in conjunction with other capital budgeting techniques to make more informed investment decisions.