Internal Rate Of Return (IRR) Method

By: EconomyWatch   Date: 30 June 2010

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Capital budgeting helps in planning out the way in which the money to be invested in a project is made use of. Capital budgeting helps in guiding the expenses. Four different methods are used in capital budgeting. The Internal rate of return (IRR) method is employed for the same purpose.

The Internal rate of return (IRR) method helps the investor to take a decision, if it is worth investing in the project. It indicates how efficient the project will be in the long run. This is in contrast to the net present value or NPV method, which decides the value.

If it is found that the internal rate of return is more than the rate of return, which could otherwise be earned if the investment was done in purchasing bonds or simply by keeping the cash in banking account, the project can be carried to completion. On the other hand, if it is found that, the internal rate of return is way below than the rate of return, which could , have been earned from alternative sources (bank interest or bonds), it is not quite desirable to invest in the project. As a rule, the internal rate of return is always compared to the alternative cause of investment. In other words, the internal rate of return method is an indicator of the feasibility of the investment.

Discount rate:

It is found that in the event when the internal rate of return is more than the hurdle rate, the investment will bring in money for the company. We know that money loses its value over time. The value of money is lost at a rate, which is referred to as the "discount rate". For instance, if the discount rate is 6% and the internal rate of return is also 6%, the investor has nothing to gain. On the other hand, if the investor becomes aware of a project, where he invests the same amount but gets higher returns, he would undoubtedly invest in the latter project. So, in this context, the internal rate of return method assists investors in comparing returns. Internal rate of return of a project, which is higher usually offers more opportunities to grow.

Drawbacks of the internal rate of return (IRR) method:
  • Internal rate of return method does not allow rating of multiple projects. The method allows rating of only one project and decides the feasibility.
  • The internal rate of return (IRR) method is not used for projects, which have a very high negative cash flow towards the end or a positive cash flow in the beginning.
  • The internal rate of return equations are solved only by iterations. The Sturm's Theorem can be made use of.

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