What does the internal rate of return (IRR) represent?

The internal rate of return (IRR) represents the discount rate at which the net present value (NPV) of a series of cash flows equals zero. It is a crucial metric in capital budgeting because it helps assess the profitability of potential investments. By determining the IRR, a company can evaluate whether a project will generate a return that meets or exceeds the required rate of return or cost of capital.

When the IRR is higher than the required rate of return, it suggests that the project is expected to create value for the firm and is a favorable investment option. Conversely, if the IRR is lower than the required rate, the project may detract from the firm's value. Thus, the concept of IRR assists financial managers in making informed decisions regarding capital allocation.

The other options do not accurately define IRR. The rate at which a company must borrow refers to financing costs, while the interest rate paid to lenders pertains specifically to external borrowing. The average return of the market does not relate directly to project-specific cash flows or the NPV assessment.