IRR answers: "What annual return does this investment actually deliver?" Technically, it is the discount rate that makes the NPV of all cash flows equal to zero. If a project has an IRR of 18% and your cost of capital is 12%, the project creates value. If IRR falls below the cost of capital, reject it.
Example: Invest $100,000 today and receive $40,000 per year for 4 years. The IRR is approximately 21.9% — this is the implied annual return. Private equity funds report IRR as their primary performance metric. Top PE firms target IRRs of 20-25%. Venture capital funds aim for 25%+ but with much higher variability.
IRR has limitations: it assumes cash flows are reinvested at the IRR itself (often unrealistic). A project with $1 million IRR of 50% might look better than one with $10 million at 20% IRR — but the second creates far more wealth. MIRR (Modified IRR) fixes the reinvestment assumption. In practice, use IRR alongside NPV — never rely on IRR alone.