Evaluation of the merits and drawbacks of the use of the internal rate of return as an investment criterion…

Posted on 30 Σεπτεμβρίου , 2006


Technically, IRR is a discount rate: the rate at which the present value of an investment is equal to the present value of the returns on this investment. The aim with IRR is to answer the question: ‘What level of interest will this project be able to withstand?’ Once we know this, the risk of changing interest rate conditions can effectively be minimised.
The internal rate of return (IRR) on a project is the rate of return where the cash inflows (net cash flows) equal the cash outflows (net investment) IRR thus is the discount rate which when applied to the cash flows yields a NPV = 0. The higher the IRR, the better; higher IRR means that the company earns a greater interest rate on the investment, when the firm have a pre-specified IRR target, if investment IRR > target IRR, then the decision is obviously positive. In all cases of fluctuations the firms IRR requirements are always less than IRR of the investment.
The Net Present Value rule, the first of the investment appraisal rules, states that managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore they should accept all projects with a positive NPV. In fact NPV presents the value of cash flows minus investment.
Assumptions are crucial in the consideration of the investments since they may impact direct the results of the investment criteria and bias a decision. Before any financial analysis can be performed, the assumptions used in the analysis must be documented and understood. In addition, the analysis must allow for the assumptions to be easily changed and the new results of the analysis immediately available. The easy changing of assumptions allows for valuable what-if analyses. In any case since assumptions may never be guaranteed they only help to derive clues of plausible scenarios that help in decisions and they never stand as the definite outcome of a speculation.
The NPV method is a way of evaluating a project by recognizing that the dollar received immediately is preferable to a dollar received at some future date. The NPV discounts the cash flow to take into the account the time value of money. This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project. In case the present value is positive, the project will be accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen.
IRR is directly linked with the NPV rate and their relation may be summarized as:
1) When the IRR = the firm’s hurdle rate, NPV = 0
2) When the IRR < the firm’s hurdle rate, NPV < 0
3) When the IRR > the firm’s hurdle rate, NPV > 0

• IRR compares what an investment is likely to earn to the firm’s “benchmark” and measures profitability in percentage terms, which is preferred by managers.
• Considers all cash flows
• Considers time value of money
• Comparable with hurdle rate

• Not applied consistently over all investment proposals, as NPV is
• Does not show dollar improvement in value of firm if project is accepted (not many people always understand what a % ratio indicates)
• IRR can be affected by the scale (size) of the project
• Possible existence of multiple IRR’ s
• In multiple changes in the sign of the cash flows, the IRR rule does not work
When using the IRR and NVP rates:
• mutually exclusive projects are always ranked the same
• direct estimates of the increase or decrease in shareholder value can be obtained
• the time value of money is taken into account
• accounting measures of profit are considered
Possible decision conflicts among NPV and IRR
An accept/reject «conflict» occurs when NPV says «accept» and IRR says «reject» or NPV says «reject» and IRR says «accept». When projects are independent, no accept/reject conflict will arise.

A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR. Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects.

Ranking conflicts arise because of:
• Timing differences in incremental cash flows
• Magnitude differences in incremental cash flows

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