Understand Internal Rate Of Return (IRR) (Part 2)

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We have looked at how we compute investment appraisal method using Net Present Value(NPV) and Internal Rate Of Return(IRR) and also understand how to interpret the individual result.

One very good point is that both NPV and IRR are able to eliminate the greatest disadvantage of ignoring the time value of money or present value unlike the other two methods -Payback and ARR.

We now focus on the advantages of using IRR:

IRR is useful for the following reasons:

• If a company had specified it’s “hurdle rate” or a required cost of capital that new projects must achieved in order to be accepted. By just calculating the IRR, it is then compared to the hurdle rate to see whether the IRR is above the rate and the project can be accepted. Incidentally, even without the hurdle rate, if the IRR rate is very high say 32%, this can some sort warrant further analysis as this high IRR rate seems to be much more than the probable opportunity cost of capital.
• IRR is a “true” return (using present value concept) on the investment compared to the other accounting rate of return.

However IRR also has its critique which is as follows:

• IRR does not tell us anything about the size or scope of a potential investment. This is especially important when we are choosing between two mutually exclusive investments, where only one of the investment projects can be chosen.

Say for example, if we are choosing two investment projects with capital outlays of $1,000 and $10,000 and the IRR of the $1,000 is higher. If we use the IRR method than the IRR which is higher will be more attractive. However, the Net Present Value of the other investment could be much high and so we make have made a less than perfect decision. Therefore, the IRR method is not suitable for making comparisons between two investment projects of different scope or differing time horizons.

For illustration purpose that IRR is not suitable to be used when we need to choose between two mutually exclusive investments:

Year	Project A Investment	Cash-flows	Project B Investment	Cash- flows
0	-$100K		-$40K
1		$40K		$20K
2		$50K		$20K
3		$70K		$30K
	NPV @10%	$20K(say)		$10K(say)
	IRR	15%		22%

Project A should be chosen if the NPV method was used whilst Project B should be chosen according to its IRR. But, by taking the differential/remaining cash-flows and calculating the NPV and IRR, we can see that this would have been a less than perfect decision.
Differential Balance of Cash-flow

Year	Investment Project A – B	Cash-flows
0	-$60K
1		$20K
2		$30K
3		$40K
	NPV @10%	$6K(say)
	IRR	14%

The differential table shows that there is still value to be gained to enhance shareholder value by investing the differential.

The other disadvantages of IRR are:

• There is technical disadvantages to using the IRR method when dealing with unconventional cash-flows.

• We can have more than one IRR depending on the flow of the cash-flows. As IRR is determined by mathematical iterations, it is possible to have two IRRs when there is more than one change in the direction of the cash-flows. In a normal investment, in the initial one to two years, there are negative cash-flow but subsequently followed by positive cash-flow. But if an investment has a negative cash flow at the end of its economiclife, the investment would actually have two IRR like in a company which is processing radioactive material materials, it will have to invest heavily at the end of the investment’s life to dispose of the radio-active waste products.

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