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Internal Rate of Return – Intro, Advantages & Disadvantages

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Internal Rate of Return – Intro, Advantages & Disadvantages, Find Complete details for IRR Like – What is Internal Rate of Return, How to calculate IRR, Formula of IRR, Advantages of IRR, Disadvantages of Internal Rate of Return etc, so in this article you can find all details for Internal Rate of Return. Now you can scroll down below n check more details….

Internal Rate of Return

Before undertaking a particular project, we need to analyze it from various angels. One of such techniques is Net Present Value that we had seen earlier. Another Important technique is by calculating the Internal Rate of Return.

Let us understand what Internal Rate of Return is & how is it calculated & analyzed.

What is IRR?

IRR is that rate of return at which the present value of cash inflows is equal to the present value of cash outflows. Thus, it is that rate at which the NPV of the project will be o & the profitability index will be 1.

For details on NPV & PI, please refer my articles :

NPV – http://caknowledge.in/net-present-value/

PI – http://caknowledge.in/profitability-index-pi-detailed-analysis/

Now, let us have a look on how Internal Rate of Return is calculated.

This is the formula for calculating NPV:

Formula of NPV CAknowledge.in

where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

As it will be required to be calculated through a computer application because of the complex nature of the formula, it is generally calculated with the help of trial & error method.

By using the trial & error method, you can use approximate rates & ascertain the NPV at that rate. A better idea would be to use two rates which have a good difference between them. So, you can understand the rate which is nearer to the required rate & then you can proceed accordingly.

There are various advantages & disadvantages of IRR.

Let us have a look on them.

Advantages

Simple

As seen above, Internal Rate of Return is easy to calculate. There is no such hard & fast formula & can be easily calculated by a layman as well.

Gives Importance To The Time Value Of Money

While other methods don’t consider effects of inflation, deflation, etc., Internal Rate of Return method gives due importance to the effect of time value of money. It considers the change in the value of rupee. Thus it indicates a true picture of the scenario.

But is also accompanied by various disadvantages.

Let us have a look on the disadvantages:

Reinvestment Aspect Is Not Considered :

There are various projects which require investment not just in the initial phase, but also over the life. IRR is unusable in such cases. Only the projects which require just one time initial outlay can be analyzed under this method. Also, future costs are not considered in this method.

Size Of The Project Is Not Considered:

If different projects have different project size, the IRR method will not suffice. This can be troublesome when two projects require a very different amount of capital out flow, but the smaller project returns a higher IRR. This would turn out to be an inappropriate method in such a case.

Thus, IRR is an excellent way to find the project with higher returns. The project having higher IRR is generally the better project.

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About CA Ridhi Dhoot

The writer is a Chartered Accountant & a Licentiate Company Secretary. You can reach out to her at [email protected]

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