Internal Rate of Return | IIR Formula, Limitations & Disadvantages

What is Internal Rate of Return?

In this topic, we will discuss on “What is Internal Rate of Return?

Have you heard this term?

The individual who have been following the finance industry they might be aware with this term.

For any beginners in the finance or stock market, they have to know this term and its usage in different areas.

You may have heard many people saying about IRR.

It is the one of the main perspective to look on making any investment decisions for large firms or for any small decision.

Starting with the Definition first,

Internal Rate of Return (IRR)

The internal rate of return (IRR) is a discounting cash flow technique which gives a rate of return earned by a project.

The internal rate of return is the discounting rate where the total of initial cash outlay and discounted cash inflows are equal to zero.

In other words, it is the discounting rate at which the net present value (NPV) is equal to zero.

The internal rate of return is used to evaluate projects or investments. The IRR estimates a project’s break even discount rate or rate of return, which indicates the project’s potential for profitability. 

Based on IRR, a company will decide to either accept or reject a project. If the IRR of a new project exceeds a company’s required rate of return, that project will most likely be accepted.

If IRR falls below the required rate of return, the project should be rejected.

If a project is expected to have an IRR greater than the rate used to discount the cash flows, then the project adds value to the business.

If the IRR is less than the discount rate, it destroys value. 

The decision process to accept or reject a project is known as the IRR rule.

Now, let’s understand about the internal rate of return formula:

What is the IRR Formula?

The IRR cannot be derived easily.

The only way to calculate it by hand is through trial and error because you are trying to arrive at whatever rate which makes the NPV equal to zero. 

For this reason, we’ll start with calculating NPV:

 

NPV Calculation Formula

Where,

 = Net After – Tax Cash inflow – Outflows during a single period t

r = Internal rate of return

t = Time period of cash flow

n = number of individual cash flows

What Does a Positive IRR Mean?

A positive IRR means that a project or investment is expected to return some value to the organization. 

A negative IRR can happen mathematically if the project’s cash flows are alternately positive and negative over its expected duration.

A negative IRR is indicative of a more complicated cash flow stream that may make the metric less useful. 

Generally, a company would decline to make an investment in something with a negative IRR.

Limitations of Internal Rate of Return

IRR allows managers to rank projects by their overall rates of return rather than their net present values.

The investment or project with the highest IRR is usually preferred.

This easy comparison makes IRR attractive, but there are limits to its usefulness: 

  • IRR works only for investments that have an initial cash outflow (the purchase of the investment) followed by one or more cash inflows. IRR can’t be used if the investment generates interim negative cash flows. 
  • IRR does not measure the absolute size of the investment or the return. This means that IRR can favor investments with high rates of return, even if the dollar amount of the return is very small. 

Overall, IRR is best-suited for analyzing Venture capital and private equity investments.

These typically have multiple cash investments and a single cash outflow at the end via IPO or sale.

What are the Disadvantages of IRR method?

As mentioned earlier, IRR is widely used and adopted by many companies in combination with other techniques for capital budgeting. However, this method has some shortcomings.

  • IRR does not take into consideration the duration of the project. Example, if the company has to choose between two projects – Project A with IRR 10% and duration is one year and Project B with IRR 15% and project duration is 5 years and the cost of capital of the company is 8% – both the projects are profitable. If the company selects Project B because it has a higher IRR it would be incorrect as the duration of Project B is longer.
  • IRR assumes that the cash flows are reinvested at the same rate as the project, instead of the cost of capital. Hence, IRR may not give a true picture of the profitability.

Given the shortcomings of the method, analysts are using the Modified Internal Rate of Return.

It assumes that the positive cash flows are reinvested at the cost of capital and not IRR.

IRR and NPV together can help one understand the profitability of the project and also choose the most suitable project with a positive NPV.

Further, users can compare the IRR of different projects and go for the most profitable one.                                

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