The Advantages & Disadvantages of the Internal Rate of Return Method
The internal rate of return or IRR method is one of several formulas you can use to evaluate capital projects. Examples of capital projects include the construction of a new site and the purchase of a competitor's business.
The IRR considers multiple cash flows during the project's life. In the first year, that cash flow may be negative and in subsequent years it may be positive.
The IRR is the rate of return you'll get when all of a project's cash flows equal a net present value of zero.
The fact that the IRR method considers the time value of money is an advantage. Since the calculation figures out the return when the project's present value is equal to zero, you'll know the minimum rate of return.
As long as that rate is positive, you'll recoup your costs and make a profit.
For instance, if the IRR is 10 percent on a five-year project that costs $10,000, you'll make 10 percent off your investment. Even though your project's future income is worth zero in today's dollars, you'll make at least 10 percent.
An advantage of the IRR method is that it is simple to interpret. The calculation gives you a rate for each project.
If you're trying to decide between two or more projects, the one with the higher IRR will be your best choice.
You may have a choice between buying a new location and building one from scratch. If the IRR for buying the location turns out to be 15 percent, while the IRR for building a location is 20 percent, you would choose to go ahead with the building project.
In order to use the IRR calculation, you'll have to estimate your initial costs. This may be difficult to pinpoint and can cause the calculation to become skewed.
Let's say you estimate the initial costs of a project to be $50,000. The estimates of your future cash flows are $100,000. This gives you a projected profit of $50,000, which is discounted to a present value of zero. So, you calculate an IRR of 35 percent.
If your actual initial costs turn out to be $80,000, your actual IRR decreases to 9.56 percent.
The IRR method is usually not the best calculation to use when you're comparing mutually exclusive projects. This means that if you decide to accept one of the projects, you can't accept the other.
The reason why the IRR method is not the best choice for comparisons is because the calculation ignores dollar amounts.
Project A may give you an IRR of 20 percent on an initial investment of $100,000. Project B may give you an IRR of 10 percent on $1,000,000.
Using the IRR percentage values, you would reject the second project even though it will result in a higher profit.