Question

What are the limitations of the IRR rule? Given these limitations, why is IRR so commonly used?

How can you use the IRR to identify the correct investment?

Answer 1

Meaning of IRR:-

Internal rate of return (IRR) is the discount rate that makes the net Present value of all cash flows (both positive and negative) equal to zero for a specific project or investment

Disadvantage:

Ignores Size of Project

A disadvantage of using the IRR method is that it does not account for the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. For example, a project with a $100,000 capital outlay and projected cash flows of $25,000 in the next five years has an IRR of 7.94 percent, whereas a project with a $10,000 capital outlay and projected cash flows of $3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger project can generate significantly higher cash flows and perhaps larger profits.

Ignores Future Costs

The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change

Ignores Reinvestment Rates

Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high number and opportunities that yield such a return are generally not available or significantly limited.

Used for IRR

The internal rate of return is used to evaluate projects or investments. The IRR estimates a project’s breakeven 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.