Knowing the IRR advantages and disadvantages is the best way to manage your investment projects. With this knowledge, you are better positioned to use IRR as a scorecard for picking or abandoning an investment project.
IRR Definition
IRR is a valuation method used to determine the attractiveness of an investment based on returns for mutually exclusive and independent projects. IRR Advantages and Disadvantages dictates its preferability. For mutually exclusive projects, alternative with the highest IRR is accepted. For independent projects, investment is acceptable if such projects’ IRR is higher than the cost of capital.
IRR Advantages and Disadvantages
Advantages of IRR
1. Considers time value of money
Since money loses value over time, the Internal Rate of Return presents an idealistic return on investment by factoring in the time value of money. It ensures cash flows are given equal weights in the calculation.
2. Better corporate decision making
By comparing different rates of return on investment, a business eventually identifies the best projects to undertake for future wealth generation. IRR is crucial in choosing the best investments to be pursued by the business, which will increase its profits over time.
Conversely, it helps to determine those investments that will not generate revenue and hence be discarded.
3. Simplicity of use
Calculating the internal rate of return is simple where excels IRR function is used. It can be simple steps to arrive at an answer. Interpretation of the solutions derived from IRR calculations is also simple enough to be understood.
4. Maximizing net present values
The internal rate of return maximizes the net present values to create an accurate picture of the performance of the company or business entity. This may be seen through the company’s efficiency, profitability, and quality.
5. Better capital management
The internal rate of return plays a crucial role in helping firms manage their capital asset effectively and benefitting the company as a whole. By deciding which investments to undertake, the company steers out of wrong decisions on investments that would derail its operations and eventually collapse.
Disadvantages of IRR
1. Ignores the size of the project
The general rule of IRR says that a project is acceptable if its internal return rate exceeds the hurdle rate. It does not offer room to consider the size of a project which may be crucial. Some projects may have low IRR but are generally too big to ignore based on their internal rates of return.
2. Ignores future-related costs
The internal rate of return only concerns cash flows without considering costs that may arise due to the purchase and usage of assets. If these costs are too much, they adversely affect a company’s profits. IRR ignores these costs, which are crucial in generating profits.
3. Ignores new rates of investment
The internal rate of return assumes the rates of new investments will remain the same, which could be better. The cash flows may be invested at different rates. The IRR may generate a value that is too high, which may not be possible, or opportunities to generate such rates of return are minimal.
How to Overcome IRR Disadvantages
To overcome above identified disadvantages of IRR, a Modified Internal Rate of Return/MIRR is used instead. It is a better approach because it considers external factors like the cost of capital and inflation. It also makes more realistic possible incomes to be generated in the lifetime of an investment opportunity.
IRR Advantages and Disadvantages Summary
| IRR Advantages | IRR Disadvantages |
| 1. Considers time value of money 2. Better corporate decision making 3. Simplicity of use 4. Maximizing net present values 5. Better capital management | 1. Ignores the size of the project 2. Ignores future-related costs 3. Ignores new rates of investment |
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