Corporate Finance - Internal Rate of Return Rule

Internal rate of return (IRR) rule take account for the time value of money. The investors will be aware of the minimum rate of return as the internal rate of return (IRR) can judge the return if the investment’s present value is equal to zero. As long as the rate is positive, the investors will recover the costs and earn a profit. For example, if the internal rate of return (IRR) is 10 percent on a four-year investment which costs about $10,000, the investors will make 10 percent off in the investment. The investors will make at least 10 percent although the investment future income is zero in today’s dollars. Calculating the interest rate at which the present value of future cash flows match with the required capital investment can be estimate through internal rate of return (IRR). Internal rate of return (IRR) take notice of the timing of cash flows in all following years, so each cash flow is given same weight by applying the time value of money. Furthermore, simple to interpret is another major advantage of internal rate of return (IRR). Internal rate of return (IRR) will provide the investors a rate for each investment. The highest internal rate of return (IRR) will be the best choice if the investors trying to select in multiple investment. In addition, the investors may confuse either buying a new location or building one from scratch. For example, if the internal rate of return for buying a new location is 15 percent but for building one from scratch is 20 percent, the investor will choose to go ahead with building project.

The limitation of internal rate of return is it does not pay attention for the size of project when it comes to compare with other projects. Cash flow are easily compared to the amount of capital outflow that producing those cash flows. This will causing difficulty when two projects need a significantly different amount of capital outflow, but the smaller project with a higher internal rate of return (IRR). For instance, Project A with a $100,000 capital outflow and projected cash flows of $25,000 in the next five years has an internal rate of return (IRR) of 7.94%, but for project B with a $10,000 capital outflow and projected cash flows of $3,000 in the next five years has an internal rate of return (IRR) of 15.20%. Applying internal rate of return (IRR) rule make the smaller project more attractive, and it will neglect the fact that the larger project can provide more cash flows and profit. Not only that, even if the internal rate of return (IRR) offer the investors to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the equal rate as the internal rate of return (IRR). The assumption is not practical because the internal rate of return (IRR) is sometimes a very high number and opportunities that yield such a return are basically not available or significantly limited.

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