Advantages and Disadvantages of Internal Rate of Return (IRR)

Advantages and disadvantages of internal rate of return are important to understand before applying this technique to the projects. Most projects are well analyzed and interpreted by this well-known technique of evaluation and selection of investment projects. This technique has certain limitations in analyzing certain special kinds of projects like mutually exclusive projects, an unconventional set of cash flows, different project lives etc.

ADVANTAGES OF INTERNAL RATE OF RETURN

The various advantages of 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 big lacking in accounting rate of return, average rate of return and Pay Back period.

Simplicity

The most attractive thing about this method is that it is very simple to interpret after the IRR is calculated. If IRR exceeds cost of capital, than accept the project not otherwise. 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.

Advantages and Disadvantages of Internal Rate of Return (IRR)Hurdle Rate / Required Rate of Return has 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. Calculation of NPV, Profitability index require hurdle rate.

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 room for estimation errors.

DISADVANTAGES OF INTERNAL RATE OF RETURN

The method of internal rate of return does not prove very fruitful under certain special type of conditions which are discussed below:

Economies of Scale Ignored

One pitfall in the use of 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 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 that the positive future cash flows are reinvested at IRR for 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 of 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 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. 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 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 till the other project ends. This point is not considered by 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 trap of Multiple IRR. In case of multiple IRR situation, it is possible to take 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 cost of capital is less than 10% or more than 30%. If cost of capital falls between 10 % and 30 %, project will not be accepted. In case of NPV is negative @ 5 %, then decision making would be reverse. 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 can not be found. IRR is discounted rate at which Present Value of Cash Inflow equals to Investment or Present value cash outflow.

Objective of wealth maximization

Importantly when there is a conflict in ranking of mutually exclusive projects between NPV and IRR, at that time, NPV criteria supersedes IRR criteria because NPV criteria exactly measures that what is the amount by which value of firm will increase. 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 that whether project is worth accepting or not, however what will be increase in wealth is not possible to be measured by IRR.

Last updated on : November 22nd, 2018

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  1. G Bornholt
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