Before making an investment decision, a company has to evaluate if a project is worth the resources required. Internal rate of return is a capital budgeting technique that calculates how much profit a project will generate. It accounts for the time value of money as part of the calculation, and the results are easy to understand. However, the rate of return is not accurate if interest rate assumptions are incorrect or if the project ever has negative cash flows.
Internal Rate of Return Basics
Internal rate of return represents the discount rate at which the present value of future cash flows equals zero. In other words, it represents the money that a company will make from an investment based on expected future cash flows. If the rate of return on the project meets a company's minimum standards, it can choose to move forward with the investment.
Time Value of Money
Business consultant Joe Knight notes that in order to properly evaluate an investment's return, you need to account for the time value of money. Unlike some other capital budgeting techniques, like the accounting rate of return and payback period method, internal rate of return considers the time value of money. Financial theory states that the earlier a company receives a payment for the investment, the more that payment is worth. Internal rate of return reflects this concept by assigning early cash payments a higher dollar value than cash payments that occur in future years. This gives the firm a more realistic sense of what the investment is worth. Accounting rate of return and payback method, on the other hand, may overestimate the investment's value.
Easy to Understand
Ultimately, corporate investment decisions often are made by executives who aren't experts in finance. Some capital budgeting techniques, like the net present value method, may be more difficult for non-financial employees to understand or interpret. Most executives are familiar with interest rates, however, which are considered in the internal rate of return method. According to the Association of Chartered Certified Accountants, these executives tend to feel comfortable with a percentage that's easily to understand and to compare to other investments.
Interest Rate Issues
In order to calculate the internal rate of return, financial analysts must estimate the return the company could get from a similar investment. Financial analysts don't have a crystal ball, however, and their predictions aren't always right. An article in the Harvard Business Review asserts that analysts predictions are often incorrect for very risky investments and investments with a long time frame. If management doesn't have a good investment alternative at the estimated interest rate or chooses not to reinvest the funds, the internal rate of return figure will be incorrect.
A significant drawback of the internal rate of return method is that the formula's algebra isn't foolproof. The internal rate of return formula functions correctly as long as all cash flows are positive after the initial investment. Columbia University material shows that the method generates multiple rates of return -- which don't represent the overall rate of return -- if the project's cash flows ever become negative. When evaluating a project that has both positive and negative cash flows, net present value may be a better option.