Advantages and disadvantages of internal rate of return are important to an understanding before applying this technique to the projects. There has to be a proper analysis and interpretation of most projects by this well-known technique of evaluation and selection of investment projects. This technique has certain limitations in analyzing certain special kinds of projects. For example, mutually exclusive projects, an unconventional set of cash flows, different project lives etc.
Table of Contents
- 1 ADVANTAGES OF INTERNAL RATE OF RETURN
- 2 DISADVANTAGES OF INTERNAL RATE OF RETURN
- 2.1 Economies of Scale Ignored
- 2.2 Impractical Implicit Assumption of Reinvestment Rate
- 2.3 Dependent or Contingent Projects
- 2.4 Mutually Exclusive Projects
- 2.5 Different Terms of Projects
- 2.6 A mix of Positive and Negative Future Cash Flows
- 2.7 Calculation of IRR is not possible
- 2.8 The objective of wealth maximization
ADVANTAGES 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. This is a huge lacking in accounting rate of return, an average rate of return and Pay Back period. One can measure IRR by calculating the interest rate at which PV of future cash flows is equal to the capital investment required.
The most attractive thing about this method is that it is very simple to interpret after the IRR is calculated. If IRR exceeds the cost of capital, then accept the project not otherwise. It is very easy to visualize for managers. That’s the reason why its preferable till the time they come across certain occasional situations like mutually exclusive projects etc.
Hurdle Rate / Required Rate of Return has Not Required
The hurdle rate is a difficult and subjective thing to decide. In IRR, there is no requirement of finding out IRR hurdle rate or the required rate of return. It is not dependent on the hurdle rate and hence the risk of a wrong determination of hurdle rate becomes less. If one calculates of net present value, profitability index, etc; it will require hurdle rate.
Required Rate of Return is a Rough Estimate
Managers make a rough estimate of the required rate of return. And the method of IRR does not completely base on the required rate of return. Once we come up to IRR, 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. Also, he can keep a room for estimation errors.
DISADVANTAGES 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. One should always prefer a project value of $1000000 with 18% rate of return over a project value of $10000 with a 50% rate of return. No need of 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 IRR method, it implicitly assumes the reinvestment of the positive future cash flows at IRR for the remaining time period of the project. 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. In addition to that making, an assumption that at one point in time, one company will have more than one reinvestment rate is not possible. If a company has more than one reinvestment rate opportunity, then it will invest at a higher rate.
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 acceptable other is not. 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. The challenge is to know which one is the best. IRR will give a percentage interpretation value which is not enough. Refer the first disadvantage of economies of scale which the IRR ignores.
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 till 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 flows, the equation of IRR is satisfied with more than one rate of return i.e. it reaches the trap of Multiple IRR. In case of multiple IRR situations, it is possible to take a decision with IRR, however, we should know that what is NPV at one cost of capital at least.
For example, IRR for a project is 10 % and 30%, and @ 5 % NPV is positive, then Project will be accepted if the cost of capital is less than 10% or more than 30%. If the cost of capital falls between 10 % and 30 %, a project will not be accepted. In case of NPV is negative @ 5 %, then decision making would be reversed. So, in this case, decision making becomes dependable to NPV and decision making becomes complicated. It is very rare that such kind of situation arises. It arises in agency deposit or such other businesses.
Calculation of IRR is not possible
If later cash inflows are not sufficient to cover initial investment, then, in that case, IRR cannot be found. IRR is discounted rate at which Present Value of Cash Inflow equals to Investment or Present value cash outflow.
The objective of wealth maximization
Importantly when there is a conflict in the ranking of mutually exclusive projects between net present value npv and IRR, at that time, NPV criteria supersedes IRR criteria because NPV criteria exactly measure that what is the amount by which value of the firm will increase. The objective of Financial Management in terms of wealth maximization is met to which extent can be measured by NPV. IRR will only be able to decide whether a project is worth accepting or not. However, what will increase in wealth is not possible to be measured by IRR.Last updated on : February 8th, 2019