An internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. An internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
The advantage of Internal Rate of Return –
The various advantages of the internal rate of return method of evaluating investment projects are as follows:
Time Value of Money: The first and the most important thing is that it considers the time value of money in evaluating a project which is a bit lacking in the accounting rate of return.
Simplicity: The most attractive thing about this method is that it is very simple to interpret after the IRR is calculated. It is very easy to visualize for managers and that is why this is preferred till the time they come across certain occasional situations such as mutually exclusive projects etc.
Hurdle Rate/ Required Rate of Return is not required: The hurdle rate is a difficult and subjective thing to decide. In IRR, the hurdle rate or the required rate of return is not required for finding out IRR. It is not dependent on the hurdle rate and hence the risk of a wrong determination of hurdle rate is mitigated.
Required Rate of Return is a Rough Estimate: A required rate of return is a rough estimate being made by the managers and the method of IRR is not completely based on required rate, of return. Once IRR is found out, we can compare it with the hurdle rate. If the IRR is far away from the estimated required rate of return, the manager can safely take the decision on either side and also keep a zoom for estimation errors.
The disadvantage of Internal Rate of Return –
The method of internal rate of return does not prove very fruitful under a certain special type of conditions which are discussed below:
Economies of Scale Ignored: One pitfall in the use of the IRR method is that it ignores the actual dollar value of benefits. A project value of $1000000 with 18% rate of return should always be preferred over a project value of $10000 with a 50% rate of return. No need for analysis, we can apparently see that the dollar benefit of the former project is $180000 whereas the latter one is only $5000. Absolutely No Comparison. IRR method will rank the latter project, with very less dollar benefit, first simply because the IRR of 50% is higher than 18%.
Impractical Implicit Assumption of Reinvestment Rate: While analyzing a project with the IRR method, it implicitly assumes that the positive future cash flows are reinvested at IRR. If a project has low IRR, it will assume reinvestment at a low rate of return and on the contrary, if the other project has very high IRR, it will assume reinvestment rate at the very high rate of return. This situation is practically not valid. At the time you receive those cash flows, having the same level of investment opportunity is rarely possible.
Dependent or Contingent Projects: Many times, finance managers come across a situation when the project under evaluation creates a compulsion of investing in other projects. For example, if you invest in a big transporting vehicle, you would need to arrange a place for parking that also. Such projects are called dependent or contingent projects which have to be considered by the manager. IRR may permit buying of the vehicle but if the total proposed benefits are wiped off in arranging the parking space, there is no point investing.
Mutually Exclusive Projects: Sometimes investors come across mutually exclusive projects which mean if one is accepted other cannot be accepted. Building a hotel or a commercial complex on a particular plot of land is an example of mutually exclusive projects. In such situations, knowing whether they are worth investing is not enough. Challenge is to know which one is the best. IRR will give a percentage interpretation value which is not enough. Refer to the first disadvantage of economies of scale which is ignored by IRR.
Different Terms of Projects: Consider two projects with different project duration. One ends after 2 years and the other ends after 5 years. The first project has an additional point of reinvesting the money which is unlocked at the end of the 2nd year for another 3 years until the other project ends. This point is not considered by the IRR method.
A mix of Positive and Negative Future Cash Flows: When a project has some negative cash flow ‘in between other positive cash flow, the equation of IRR is satisfied with more than one rate of return i.e. it reaches the imp of Multiple IRR.