Strengths & Weaknesses of Internal Rate of Return (IRR)

The internal rate of return (IRR) is an appraisal technique that utilizes discounted cash flows – taking into account the timing and magnitude of cash flows. It is a rate that the present value of the expected future cash flows with the cost of the investment. In other words, it is the discounting rate that equates NPV to zero. The internal rate of return is also described as the yield on investment, marginal efficiency of capital, time-adjusted rate of internal return, or the rate of return over cost.

The internal rate of return as an investment appraisal technique has several advantages and disadvantages

Strengths/Advantages

The IRR method is like the NPV method. It is a popular investment criterion since it measures profitability as a percentage and can be easily compared with the opportunity cost of capital. IRR method has following merits:

  • Like the NPV method, IRR recognises the time value of money.
  • Another advantage of IRR is that it is based on cash flows, not accounting profits. It considers all cash flows occurring over the entire life of the project to calculate its rate of return.
  • More easily understood than NPV by non-accountant being a percentage return on investment.
  • For accept/ reject decisions on individual projects, the IRR method will reach the same decision as the NPV method.
  • Shareholder value is another strength of IRR: This capital budgeting technique is consistent with the shareholders’ wealth maximization objective. Whenever a project’s IRR is greater than the opportunity cost of capital, the shareholders’ wealth will be enhanced.

Weaknesses and Disadvantages

Like the NPV method, the IRR method is also theoretically a sound investment evaluation criterion. However, IRR rule can give misleading and inconsistent results under certain circumstances. Here we briefly mention the problems that IRR method may suffer from.

  • Does not indicate the size of the investment, thus the risk involve in the investment.
  • Assumes that earnings throughout the period of the investment are reinvested at the same rate of return.
  • It can give conflicting signals with mutually exclusive project.
  • If a project has irregular cash flows there is more than one IRR for that project (multiple IRRs).
  • Another disadvantage of internal rate of return is that it is confused with accounting rate of return.
  • Multiple rates: A project may have multiple rates, or it may not have a unique rate of return.
  • Mutually exclusive projects: It may also fail to indicate a correct choice between mutually exclusive projects under certain situations

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