Monday, January 25, 2010


Evaluation of Internal Rate of Return Method

Internal rate of return (IRR) method is like the net present value (NPV). It is a popular investment criterion since it measures profitability as a percentage and can be easily compared with the opportunity cost of capital. Internal rate of return (IRR) method has following merits:
  • Time value. The internal rate of return (IRR) method recognizes the time value of money.
  • Profitability measure. It considers all cash flows occurring over the entire life of the project to calculate its rate or return.
  • Acceptance rule. It generally gives the same acceptance rule as the net present value (NPV) method.
  • Shareholder value. It is consistent with the shareholders wealth maximization objective. Whenever a project’s internal rate of return (IRR) is grater than the opportunity cost of capital, the shareholders wealth will be enhance.

Here is the briefly mention the problems that internal rate of return (IRR) method may suffer from.

  • Multiple rates. A project may have multiple rates, or it may not have a unique rate of return. These problems arise because of the mathematics of internal rate of return (IRR) computation.
  • Mutually exclusive projects. It may also fail to indicate a correct choice between mutually exclusive projects under certain situations.
  • Value additively. Unlike in the case of the net present value (NPV) method, the value additively principle does not hold when the internal rate of return (IRR) method is used internal rate of returns (IRRs) of projects do not add. Thus, for projects A and B, IRR (A) + IRR (B) need not be equal to IRR (A+B).

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