The advantages and disadvantages of the internal rate of return are important to understand before applying this technique to specific projects. There must be a proper analysis conducted and an interpretation of most projects by this well-known evaluation technique and selection of investment projects. Internal rate of return has certain limitations in analyzing certain special kinds of projects, such as mutually exclusive projects, an unconventional set of cash flows, different project lives, etc.
Advantages of IRR
The various advantages of the internal rate of return method of evaluating investment projects are as follows:
- Advantages of IRR
- Disadvantages of IRR
- Economies of Scale Ignored
- Impractical Implicit Assumption of Reinvestment Rate
- Dependent or Contingent Projects
- Mutually Exclusive Projects
- Different Terms of Projects
- Mix of Positive and Negative Future Cash Flows
- Calculation of IRR is not Possible
- Objective of Wealth Maximization
- Difference between IRR and Rate of Return
Time Value of Money
The first and the most important thing is that the internal rate of return considers the time value of money when evaluating a project. This is a massive downfall in the accounting rate of return, the average rate of return, and Pay Back period. One can measure IRR by calculating the interest rate at which the PV of future cash flows equals the capital investment required.
The most beautiful thing about this method is that it is very simple to interpret after calculating the IRR. If the IRR exceeds the cost of capital, then accept the project, but not otherwise. This is very easy to visualize for managers, which is why it’s preferable. Unless they come across occasional outstanding situations, like mutually exclusive projects, etc.
Hurdle Rate / Required Rate of Return Is Not Required
The hurdle rate is a subjective and challenging thing to decide. In IRR, there is no requirement for finding out the IRR hurdle rate or the required rate of return. It is not dependent on the hurdle rate, so the risk of a wrong determination of the hurdle rate is diminished. If one calculates the net present value, profitability index, etc., the hurdle rate will require.
Required Rate of Return is a Rough Estimate
Managers make a rough estimate of the required rate of return, but the method of IRR is not completely based on the required rate of return. Once we come up to the IRR, we can compare it with the hurdle rate. If the IRR is far from the estimated required rate of return, the manager can safely decide on either side. Also, he can maintain room for estimation errors.
Disadvantages of IRR
The method of internal rate of return does not prove very fruitful under some special types of conditions, which are discussed below:
Economies of Scale Ignored
One pitfall in using the IRR method is that it ignores the actual dollar value of benefits. One should always prefer a project value of $1,000,000 with an 18% rate of return over a project value of $10,000 with a 50% rate of return. There is no need for in-depth analysis; we can see that the dollar benefit of the former project is $180,000, whereas the latter project’s dollar benefit is only $5,000. There is no comparison as to which is more worthwhile. The IRR method will rank the latter project—with a much lower 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 the reinvestment of the positive future cash flows at IRR for the remaining time period of the project. If a project has a low IRR, it will assume reinvestment at a low rate of return; on the contrary, if the other project has a very high IRR, it will assume a reinvestment rate at a very high rate of return. This situation is not practically valid. When you receive those cash flows, having the same level of investment opportunity is rarely possible. In addition to that, assuming 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, it will invest at a higher rate.
Dependent or Contingent Projects
Finance managers often come across a situation when the project under evaluation creates a compulsion to invest in other projects. For example, if you invest in a big transporting vehicle, you will also need to arrange a parking place it. Such projects are called dependent or contingent projects and must be considered by the manager. IRR may permit the buying of the vehicle, but if the total proposed benefits are wiped off by having to arrange the parking space, there’s no point in investing.
Mutually Exclusive Projects
Sometimes investors come across mutually exclusive projects, which means that if one is acceptable, the other is not. Building a hotel or a commercial complex on a particular plot of land is an example of a mutually exclusive project. In such situations, knowing whether they are worth investing in is not enough. The challenge is to know which investment is the best. The IRR method will give a percentage interpretation value, but that is insufficient. This is connected to the first disadvantage of economies of scale, which the IRR ignores.
Different Terms of Projects
Consider two projects with different project durations. 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.
Mix of Positive and Negative Future Cash Flows
When a project has some negative cash flow between other positive cash flows, the equation of the IRR method is satisfied with more than one rate of return, i.e., it reaches the trap of Multiple IRR. In the case of multiple IRR situations, it’s possible to decide with IRR, but we should know what is NPV at one cost of capital at least.
For example, if the 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. If the NPV is negative @ 5%, the decision-making would be reversed. So, in such a case, the decision becomes dependent on NPV, which becomes more complicated. It is very rare that such a situation arises and is mainly found in agency deposits or other similar businesses.
Calculation of IRR is not Possible
If later cash inflows are not sufficient to cover the initial investment, in that case, IRR cannot be found. IRR is then a discounted rate at which the Present Value of Cash Inflow equals the Investment or Present value of cash outflow.
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 supersede IRR criteria because NPV criteria precisely measure the amount by which the value of the firm will increase. The objective of Financial Management in terms of wealth maximization is met to the extent NPV can measure it. IRR will only be able to decide whether a project is worth accepting or not. But what increase in wealth will occur cannot be measured by IRR.
Difference between IRR and Rate of Return
There is a minor difference between the two, and hence, several times, both are used interchangeably. However, for long-term investment decisions, it makes a big impact.
Rate of Return (ROR) is the return earned by the company or the investor from that particular investment over the period of calculation. The calculation is simple, wherein total returns from that stock or security or investment earned over the given time frame are divided by the quantum of investment. And then it is expressed in terms of percentage.
Thus, the formula is Return on Investment = Total Returns*100 / Quantum of Investments.
On the face of it, IRR also is similar. However, the moot difference is that IRR reduces and expresses this return as an annualized percentage. ROR may be for a single year or multiple years and could be pretty long-term. Hence, ROR does not give the annualized return on investment, which is of more importance for making investment decisions.
If the return is calculated for one year or less than a year. Then the ROR and IRR will be the same. It will have no difference. However, the moment you extend the return period to multiple years, both the values will be different. Secondly, the longer the period, the wider will be the gap between the two types of returns shown.
Refer ROI vs. IRR.