IRR Rule

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DEFINITION of 'IRR Rule'

A measure for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or investment is greater than the minimum required rate of return – the cost of capital – then the decision would generally be to go ahead with it. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.

BREAKING DOWN 'IRR Rule'

The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. In general terms, a company that has to choose one, among several similar projects with equivalent degrees of risk, may go with the one that provides the highest IRR.

The IRR rule is one among a number of rules used to evaluate projects in capital budgeting. However, it may not always be rigidly enforced. For example, a company may prefer a project with a lower IRR over one with a higher IRR because the former provides other intangible benefits such as being part of a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR, because of the higher cash flows generated by the larger project.

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