The internal rate of return (IRR) in lending is a financial metric used to evaluate the profitability of an investment or project over time, specifically in the context of cash flows associated with loans or financing arrangements. It is the discount rate that makes the net present value (NPV) of all cash flows (both incoming and outgoing) from an investment equal to zero. 

Here’s a detailed explanation of IRR and its relevance in lending:

IRR is calculated based on the cash flows generated by an investment, which include both the initial investment outflow (e.g., loan disbursement) and subsequent inflows (e.g., loan repayments). In lending, cash flows may include the initial loan amount, interest payments, and any fees or financing charges associated with the loan.

The concept of IRR incorporates the time value of money — it recognizes that cash received today is worth more than cash received in the future. IRR represents the annualized effective compounded return rate that can be earned on the invested capital, accounting for the timing and size of cash flows.

Calculation

Because IRR is typically calculated through iterative methods, financial software that can solve for the rate that sets the NPV to zero is often employed.

The formula for calculating NPV is: 

NPV=∑ (CFt  ÷ (1 + r))^t

Where:

• CFt = cash flow at time t

• r = discount rate (or IRR in this case)

• t = time period

Though IRR is an important financial metric that supports practical decision-making and enables comparisons between different lending options, it is essential to understand its limitations, which include:

• It assumes that interim cash flows are reinvested at the same rate as the IRR, which may not always be realistic.

• Projects with non-conventional cash flows (multiple sign changes in cash flow — positive and negative — over time) can result in multiple IRRs, making interpretation challenging.