Internal Rate of Return - IRR

Internal Rate of Return is one of the most frequently discussed discounted cash flow technique in capital budgeting. This is one of the best tools for making investment decisions, especially important when you have two mutually exclusive projects. IRR is basically the discount rate at which present value of future after tax cash flows equals the total investment outlay. In other words, this is discount rate which produces a zero NPV (Net present value). Hence, at this rate, present value of cash inflows equals the present value of cash outflows.

Accept the project

1. If IRR is greater than Cost of capital (WACC).

2. In case of mutually exclusive projects, project with higher IRR shall be chosen.

Merits of IRR

1. It considers TVM (Time value of money).

2. This is based on the cash flows rather than accounting profit.

Drawbacks of IRR

1. Tedious to calculate due to use of trial & error approach and interpolation techniques.

2. Biased towards smaller projects which are more likely to yield higher returns over the larger projects which is spread over many years.

3. Multiple IRR can be obtained sometimes when we have cash infusion in the middle of the project.

4. Sometimes the IRR is indeterminable. In other words, there is no real IRR. Consider a proposal with annual cash flows of $(1,000), $1,500 & $(1,000).