Question

what you understand by the Internal Rate of Return? How is it useful in making
capital budgeting decisions? Please explain briefly.

Answer 1

Internal Rate of Return(IRR) is one of the techniques used in evaluating Capital budgeting decisions.

It is the rate of return at which the net present value(NPV) of a project becomes zero.

It is called 'Internal' because it doesn't consider external factors such as inflation.

It is a discounting cash flow technique that gives a rate of return earned by the project/investment.

IRR = (Cash flows / (1+r)î) - Initial Investment

where,

r = cost of capital

The IRR rule is as follows:

IRR > Cost of Capital = Accept Project

IRR < Cost of Capital = Reject Project

The primary advantage of implementing the internal rate of return as a decision-making tool is that it provides a benchmark figure for every project that can be assessed in reference to a company's capital structure.

A drawback of IRR is that if in a project the cash flow streams are unconventional i.e., there are additional cash outflows after the initial investment then IRR might not exist or there may be multiple IRRs.

Using IRR exclusively can lead you to make poor investment decisions, especially if comparing two projects with different durations.

it assumes all positive cash flows of a project will be reinvested at the same rate as the project, instead of the company’s cost of capital. Therefore, the internal rate of return may not accurately reflect the profitability and cost of a project.

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.