Internal rate of return (IRR) definition
/What is the Internal Rate of Return?
The internal rate of return (IRR) is used to calculate the projected profitability of a proposed investment. It is the rate of return at which the present value of a series of future cash flows equals the present value of all associated costs. A proposed investment with a high IRR is usually considered a desirable use of funds.
When to Use the Internal Rate of Return
IRR is commonly used in capital budgeting, where the IRR of a proposed investment should be higher than an entity's cost of capital before the investment will be accepted. If the IRR for the cash flows associated with a proposed project is unusually high, then it is reasonable to invest in the project, subject to the availability of a sufficient amount of cash. Conversely, if a business cannot locate any projects with an IRR higher than the rates to be earned on investment-grade securities, then a reasonable alternative is to invest excess cash in the securities until better internal projects can be devised.
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When Not to Use the Internal Rate of Return
The IRR is not applicable when a business is forced to make an investment for safety or legal reasons, in which case no rate of return at all is acceptable.
This analysis method provides no guidance on which project to select when there are two or more proposed projects having identical rates of return. In this situation, other analysis methods must be used. This method also provides no guidance when deciding whether to invest in the bottleneck operations of an entity (known as constraint analysis).
Disadvantages of the Internal Rate of Return
There are several disadvantages associated with using the internal rate of return, which are as follows:
Assumes reinvestment at the same rate of return. IRR assumes that interim cash flows are reinvested at the same rate as the calculated IRR, which may not be realistic. If the actual reinvestment rate is lower than the IRR, the project may generate less return than projected.
Ignores absolute values. IRR only provides a rate of return and does not account for the scale or size of the investment. For example, a smaller project with a higher IRR might be less profitable in absolute terms than a larger project with a lower IRR.
Ranking conflicts with NPV. IRR may rank projects differently than net present value, especially for mutually exclusive projects, because it ignores the magnitude of cash flows.
Sensitivity to timing of cash flows. IRR can favor projects with early returns, even if later cash flows are more substantial.
Ignores the cost of capital. IRR does not explicitly account for the project’s cost of capital, which could lead to suboptimal decisions.
Subject to misinterpretation. IRR is often misinterpreted as the project’s actual rate of return, while it merely represents the discount rate that makes NPV zero.
Short-term bias. IRR may favor shorter projects with quicker returns over longer-term projects with higher overall returns. For this reason, comparing projects with different lifespans using IRR can lead to incorrect conclusions.