Internal Rate of Return (IRR)

Capital Budget

The Internal Rate of Return (IRR) for a project is the interest rate (that is, the discount rate) at which the
present value of its expected cash inflows equals the present value of its expected cash outflows. In other words, the IRR is the interest (discount) rate at which the NPV is equal to zero.

To evaluate a project’s IRR, compare it with the firm’s required rate of return for the project. If the IRR is higher than the project’s required rate of return, the investment is acceptable. If its IRR is lower than the required rate of return, the investment should not be made.

Evaluating IRR

If the IRR is higher than the required rate of return management has established for the project (or the hurdle rate), the project is acceptable. If the IRR is lower than the required rate of return, the project is not acceptable and should not be considered further.

Remember that the IRR is a rate, in contrast to NPV, which is a monetary amount.

The IRR calculation incorporates an assumption that the cash inflows from the project can be reinvested at the project’s Internal Rate of Return; however, the cash inflows from the project may not be able to be reinvested at the assumed rate. If the cash inflows cannot be reinvested at the Internal Rate of Return, then the IRR will not represent a project’s true rate of return.

The modified IRR attempts to deal with this problem. The modified IRR incorporates an assumption that the cash flows received from the project are reinvested at the company’s cost of capital rate, rather than the IRR rate.

Benefits of the Internal Rate of Return Method of Capital Budgeting

  1. As a discounted cash flow method, the IRR accounts for the time value of money.
  2. The IRR can be compared with a required rate of return that is based on market return rates for similar investments or another hurdle rate chosen by management.
  3. It is easier for managers to understand and interpret than net present value.

Limitations of the Internal Rate of Return Method of Capital Budgeting

  1. The IRR incorporates an assumption that the cash inflows from the project will be reinvested at the Internal Rate of Return. If that is not a valid assumption, the calculated IRR will not represent the project’s true rate of return.
  2. If a project is nonconventional (has a negative cash flow or flows after Year 0), it will have more than one IRR, or the IRR may not be able to be calculated.
  3. When investments are mutually exclusive and are of different sizes or have different cash flow patterns, the information provided by the IRR may not be useful for decision making.
Leave a comment