INTERNAL RATE OF RETURN (IRR)
An internal rate of return of a project is the discount rate which makes its NPV=0 or it is the discount rate which equates the present value of future cash flows with the initial investment. In this method, the rate of return is calculated by trial and error method. This technique is also called as “Marginal Rate of return” or “Time Adjusted Rate of Return” or “Yield on Investment”.
ADVANTAGES OF INTERNAL RATE OF RETURN (IRR)
- It considers the time value of money.
- It takes into account the total cash inflows and cash outflows of the project.
- It doesn’t use the concept of the required rate of return.
- Decisions are taken immediately by comparing IRR with the cost of capital.
- It gives the appropriate rate of return or nearest rate of return.
- It helps in achieving the basic objective of maximization of shareholders wealth.
DISADVANTAGES OF INTERNAL RATE OF RETURN (IRR)
- It is very difficult to calculate in case of multiple cash flows.
- Multiple IRR, which leads to difficulty in interpretation.
- It makes an assumption that all future cash inflows of a proposal are reinvested at a price equal to the IRR, which may not be practically valid.
ACCEPTANCE RULE OF IRR METHOD
The IRR is compared with cut off rate i.e. cost of capital.
- If IRR > Cut-off rate, project is accepted,
- If IRR < Cut-off rate, project is rejected,
- If IRR = Cut-off rate, the project may or may not be accepted.