Advantages & Disadvantages of the IRR Method of Investment Appraisal

One of a business' most important tasks is to determine where to invest its resources. Internal rate of return (IRR) is used by businesses to determine which investments to pursue. Calculating IRR can be a complicated, time-consuming process and requires a business to consider several factors. As a result, it is vital to consider the advantages and disadvantages of this methodology.

IRR Method Defined

IRR is premised on discounted cash flows (DCF). DCF argues that a dollar held today is worth more than a dollar received in the future because you can invest the currently held funds so it is “worth more” in the future. IRR allows you to see how much more that dollar would be worth in the future if you invested it in a project. If you are able to estimate the amount of income a business could generate through a project and when that income would be earned, you can use IRR to calculate a percentage return on the investment that would be adjusted based on DCF considerations. By comparing the return percentage to a predetermined required rate of return for any project to be profitable to the business, you can determine the best investment opportunities.

Advantages

IRR helps evaluate individual projects as investment opportunities. It takes into account the time value of money and adjusts for the risk that the project will not meet the income projections. Most importantly, IRR allows you to determine if the project increases the firm value and the percentage of return in comparison to the initial investment.

Disadvantages

IRR requires a complicated calculation that can only be solved through guess-and-check or a computer spreadsheet. For IRR to work, the cash flows have to be conventional in that the project has to have an initial negative cash flow, the investment, with all remaining cash flows being positive. Also, if you can only choose one of two projects, IRR may not be the best method to determine which one to choose. IRR expresses return on the return on investment, which means that it is possible that you could choose the project with the highest percentage return but that would not maximize the value to the firm. Assume project A has a 15 percent return on a $100 investment and project B has a 10 percent return on a $200 investment. You can only choose one project. If you use IRR, you would only see the percentages and choose project A. However, the more valuable option would be project B, because it has a $20 return in comparison to A’s $15 return.

Net Present Value

Net present value (NPV) is an alternative valuation method for evaluating investment that also includes DCF principles in its calculations. Unlike IRR, NPV values the future cash flows from a project in “current” dollars. If the future cash flows in current dollars exceed the present value of the expense, the business should take the project. Like IRR, it takes the time value of money and risk into consideration, but unlike IRR it is able to establish the value-maximizing choice when comparing two mutually exclusive projects. However, some consider seeing the investment return as a percentage to be superior to seeing it expressed in present value dollars.

References

• BusinessDictionary.com: Definition of Internal Rate of Return
• BusinessDictionary.com: Definition of Discounted Cash Flow
• Pamela Peterson-Drake: Advantage and Disadvantages of the Different Capital Budgeting Techniques
• University of Pittsburgh: Capital Budgeting: Investment Criteria
• Food and Agricultural Organization of the United Nations: Chapter 6 – Investment Decisions – Capital Budgeting