Question

What are the advantages and disadvantages of IRR?

Answer 1

IRR stands for internal rate of return. IRR is a capital budgeting technique and it is a rate at which sum of present value of cash inflows equal to cash outflow. It is a rate at which NPV is zero. so a project would be selected for investment if IRR is greater than or equal to Minimum required rate of return otherwise it is rejected.

Advantages of IRR-

1-It considers into consideration the concept of the time value of money

2. The cash flow of the project is considered over the entire economic life of the project. so cash flow through out the life of project are considered

3. There is no need of the hurdle rate or required rate of returnof cost of or cut off rate to calculate IRR

4.The ranking of project proposals is very easy under Internal Rate of Return since it indicates percentage return.

Disadvantages:

IRR is based on the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project. in actual life it is rarely possible.

2. It involves tedious and complicated procedure for calculations.

3. IRR gives importance only to the profitability but does not consider the earliest recovery of capital expenditure. The reason is that sometimes Internal Rate of Return method favors a project which comparatively requires a longer period for recouping the capital expenditure. Under the conditions of future is uncertainty, sometimes the full capital expenditure can not be recouped if Internal Rate of Return followed.

4. The results of Net Present Value method and Internal Rate of Return method may differ when the projects under evaluation differ in their size, life and timings of cash inflows.