IRR (Internal Rate of Return)
Internal Rate of Return (IRR) is a very popular technique for evaluating future projects and determining which one of them you should pursue. This helps you to analyze and interpret most of the projects in the best manner possible. However, when it comes to certain types of projects such as different project lives and unconventional sets of cash flow, IRR has some limitations.
Some of the most common advantages of IRR are as following.
- Simplicity: The best thing about the internal rate of return is that it is very easy to use and applicable to the majority of the projects. Managers and CFOs like to use this method to analyze the projects unless they confront occasional odd situations such as mutually exclusive projects.
- Time Value of Money: Other methods to analyze projects such as accounting rate of return ignore the time value of money, but this is the not the case with IRR. This very method takes help of time value of money while analyzing projects, resulting in correct predictions most of the time.
- No Hurdle Rate: Hurdle rate creates a lot of problems while analyzing projects. Fortunately, you do not require hurdle rates while calculating the IRR for any project. IRR reduces the chances of wrong determinations because it does not rely on hurdle rate at all.
In fact, you can compare both IRR and Required Rate of Return (Hurdle Rate). You can decide in favor or against the project if the difference between estimated hurdle rate and internal rate of return is very high. This also gives you an opportunity to keep some room for possible estimation errors.
IRR also has some disadvantages and following lines explain some of those.
- Mutually Exclusive Projects: Mutually exclusive projects mean that you can accept only one of the potential projects. In this particular case, internal rate of return will only give the percentage value for the project that is not enough to decide which projects is better and worth spending.
- Economies of Scale: IRR does not determine the value of the projects in terms of actual value of the dollar. For instance, you will apparently accept the project valued $2,000,000 with 15% rate of return as compared to the project valued $10,000 with 50% rate of return. This is because the dollar benefit value of the first project is $300,000 and that of the second project is mere $5,000. However, the IRR will decide in favor of the second project simply because its higher IRR that is 50%.
- Dependent or Contingent Projects: Sometimes, project managers have to invest in other projects due to the project under consideration. For instance, if you are going to launch a taxi service, you will have to find a parking space as well. If you analyze the projects using IRR, it may permit you to start taxi service but there is no point investing if the money spent on acquiring the parking space whips of the total benefits.
- Mixed Future Cash Flows: The IRR method of evaluation a project might give you a multiple IRR value if there is a negative cash flow in between positive cash flows. In this case, the multiple rates of returns will satisfy the IRR equation, resulting in false analyzes and calculations.