Question

Why do you think IRR continues to be as popular in practice as it is? Additionally if you were looking at a sizable investment in a product line -- what additional method(s) would you use to make the decision and why?

Answer 1

Answer : IRR (internal rate of return) means point at which present value of cash inflows are equal to present value of cash outflows. iRR is popular becasue of the following reasons:

1)The IRR makes it easy to measure the profitability of your investment and to compare one investment's profitability to another investment

2)If the IRR is better than average or exceeds your company’s cost of capital, then invest in the project. if IRR is less than company's cost of capital we can reject the proposal.

3)If choosing between multiple investments, choose the investment with the highest IRR, assuming all exceed the cost of capital.

4)one popular scenario for IRR is comparing the profitability of setting up new operations with that of expanding existing ones.

5) IRR takes into account multiple periodic cash flows–reflecting the fact that cash inflows and outflows often constantly occur when it comes to investments.

6) it takes in account time value of money and discounting factor while calculating cash inflows and outflows.

7) it balances equally  present value of cash inflow and present value of cash outflow.

when the company looking for sizable investment in product line the following other methods must take it account:

1) Payback Period: means how much period it will take to recover initial investment and how fast or early project or product line recovers our initial investment amount is called payback period.

the above method is useful to know within how much period the product line recovers initial investment. the product line which recover earlier we choose to invest and accept the product line.

2) Net Present Value : Means the difference between present value of cash inflows and present value of cash outflows is known as NPV. this method has the following advantages;
1) it takes into account time value of money

2) to know profitability of different project under consideration.

3) the project which gives highest NPV will choose or accept the project to invest.

4) in case of mutually exclusive projects confornted with IRR or NPV based accept/ rejection criteria. we will prefer NPV of project over IRR of project.

5) It takes into account entire cash flows of the project.

3) Profitability index : it describes an index that represents the relationship between the costs and benefits of a proposed project. it is the ratio between the present value of future expected cash flows and the initial amount invested in the project.

1) A PI is greater than 1.0 is deemed as a good investment project, with higher values corresponding to more attractive projects.

2) Under capital constraints and mutually exclusive projects, only those with the highest PIs of the projects should be undertaken.