Page 133 - DMGT409Basic Financial Management

Basic Financial Management

Notes Merits of IRR

1. IRR attempts to fi nd the maximum rate of interest at which funds invested in the project
could be repaid out of the cash inflows arising from that project.

2. It considers the time value of money.

3. It considers cash flows thought out the life of the project.

4. It is not in conflict with the concept of maximizing the welfare of the equity shareholders.
5. It is calculated by the method of trial and error, usually it gives more psychological
satisfaction to the user.
6. It is consistent with the objective of shareholders; wealth maximization.

Demerits of IRR

1. Calculation of IRR is quite tedious and it is difficult to understand.

2. Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate

in the new project. However, reinvestment of funds at the cut-off rate is more appropriate
than at the IRR. Hence, NPV method is more reliable than IRR to ranking two or more
projects.

3. It implies that profits can be reinvested at internal rate of return, which is not logical.
4. It produces multiple rate of returns which can be confusing.

5. It does not help in the evaluation of mutually exclusive projects, since a project with
highest IRR would be selected. However, in practice, it may not turn out to be the one,

that is the most profitable and consistent with the objective of shareholders i.e. wealth
maximization.
6. It may not give fruitful results in case of unequal projects life, unequal cash outfl ows, and
difference in the timing of cash fl ows.

Note Comparison of NPV and IRR Methods
NPV Method IRR Method
1. Interest rate is a known factor 1. Interest rate is an unknown factor
2. It involves computation of the amount that 2. It attempts to find out the maximum rate of

can be invested in a given project so that the an- interest at which funds are invested in the proj-
ticipated earnings will be sufficient to repay this ect. Earnings from the project in the form of cash

amount with market rate of interest. flow will help us to get back the funds already

invested.

3.It assumes that the cash inflows can be rein- 3. It also assumes that the cash inflows can be re-

vested at the discounting rate in the new proj- invested at the discounting rate in the new proj-
ects. ects.
4. Reinvestment is assumed to be at the cut-off 4. Reinvestment in funds is assumed to be at the
rate. IRR.

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