Question

What does IRR mean? How it is estimated? Be specific. Are there problems with IRR? Explain.

Answer 1

IRR is called internal rate of return. it is the rate at which sum of present value of cash inflow equal to cash outflow. IRR is the rate at which NPV is zero. IRR is a technique of capital budgeting and in making decisions related to Investment IRR is frequently used as a technique of capital budgeting. According to the decision criteria, any project is selected when IRR of the project is either equal to or more than the minimum required rate of return.

IRR can be calculated either by trial and error method in which NPV is calculated at different discount rated and at which NPV is zero that would be rate of IRR.

Apart from this IRR can be obtained with the interpolation between two discount rate.

First we will calculate NPV at a minimum required rate of return, at this either the NPV is positive or negative, if it is positive we will take another higher rate for discounting at which NPV is negative and vice versa.

Once we will get Positive and negative NPV we will calculate IRR with the help of following formula:

IRR =lower discount rate + [lower rate npv/(lower rate npv+higher rate NPV)*difference in discount rates.

Apart from this we can also used finance calculator or any spreadsheet to calculate IRR. like in MS excel we can use irr function to calculate the irr.

Limitations of IRR

This technique has certain limitations in analyzing certain special kinds of projects like mutually exclusive projects, an unconventional set of cash flows, different project lives etc