Essay on Importance of Internal Rate of Return Method
Added on 2020-05-28
12 Pages3106 Words464 Views
1Internal rate of Return
2IntroductionWhen any decision regarding the capital expenditure has been made in the organization,the management wants to know that what the whole project will cost and what return that projectwill give if it has been selected. Management always wants to select such investment proposalsthat provide maximum profits and returns with minimal risks from the available list of mutuallyexclusive investment projects. In order to determine the best capital expenditure proposal, projectand portfolio of the desired investments, there are several capital finance evaluation methodsavailable that can be used by the management to choose the best project from the availableproject list. Management can rely on such capital investment evaluation methods in order todecide the acceptance and rejection of the project. Some of the commonly used capitalinvestment evaluations methods are pay back method, accounting rate of return, net presentvalue and internal rate of return. Among all these methods internal rate of return is the mostcommon and also important methods that is used by the potential investors to decide whether totake up the investment in particular or not.Capital investment decisions are regarded as the most important decisions that are takenby the management to earn the maximum return with minimum risk. The main goal of the capitalinvestment decisions is to increase the value of firm as the substantial cash outlays are involvedand these decisions if once implemented that it cannot be reversed. In this essay there will be discussion regarding the importance of the internal rate ofreturn method and how the IRR is the useful indicator of the potential project performance evenif there is no capital rationing. Numerical examples are used to evaluate this statement and tosupport the findings.
3Internal rate of return The internal rate of return (IRR) has been defined as the interest rate or percentage of thediscount rate where the project will be going to break even. So it can said that IRR of any projectrefers to such rate of return that equal the cash flows form the project to zero. In other words itcan be said that it provides that interest rate if used as the discount rate or cost of capital incalculating the net present value will give answer as zero. It can be said that internal rate ofreturn provides the information about the return that project will provide if that project isimplemented. In financial term it can be understand as the financial metric of cash flow that isprimarily used for the project appraisal, project evaluation, project proposal analysis and capitalacquisition decisions (Bromwich and Bhimani, 2005). The internal rate of return can be simplyunderstood from this equation: NPV = ∑ [CFt / (1 + IRR) t] =0, where, CFt represents the cashflow at time t. Here, NPV is given the value zero because if the calculated IRR rate used fordiscount cash flows than certainly it will be zero as at this value the project is providing thereturns to the company. So, it can be said that by sampling calculating the internal rate of returnone can judge whether the project is useful for the investment point of view of not. If the IRR islower than the cost of capital to the company than it is costlier for the management, but if theIRR is gather than the cost of the capital than such project can be accepted as it is increasing theshareholders value (Brealey, Myers and Marcus, 2007). Importance of the internal rate of return and why it is different from other methodsAll capital budgeting methods are used to evaluate the performance of the potentialinvestment projects but IRR is most successful indicator for evaluating the investment appraisal.There are numerous advantages that made it important and different from others. Firstly it must
4be note that internal rate of return method is based on the time value of money so all the cashflows are discounted that desired interest rates so that IRR can be computed. Discounting thecash flows to the present values helps to give equal weight to all the future cash flows. IRR iseasy to measure and it provides useful means to evaluate the projects that are underconsideration. Using the IRR method to decide which project has to be selected from theavailable projects, it proves to very useful as it make it very easy to compare. The mostimportant advantage that makes it different from others while making the calculation for theinternal rate of return there is that there is no requirement of cost of capital or discount ratewhereas in rest of methods there is requirement of cost of capital in order to make calculation(Damodaran, 2011). The cost of capital is discount rate that is fixed by the management for thecapital rationing purpose. So it can be said that IRR can be used without the decisions of capitalrationing for evaluating the potential projects. Internal rate of return does not give emphasis tothe capital rationing decisions made by the company as this method is truly based on theassumptions that every project provides some return and through using that rate of return projectscan be compared with one another. IRR is vey useful as compared to NPV method as NPVconsidered various factors such as taxation rate, depreciation expenses, and cost that arises infuture while IRR clearly ignores all such factors aim of the IRR is to calculate the rate of returnwhere the NPV is zero. Using IRR as the method of evaluation one can compare all the projectsthat are under consideration without even using the capital rate decided by the management forevaluation purpose (Davies and Crawford, 2011). The IRR is a useful indicator of potential project performance even if there is no capitalrationing
End of preview
Want to access all the pages? Upload your documents or become a member.
Related Documents
Evaluate the Usefulness of Different Methods and Differenceslg...
|9
|1404
|95
Financial Analysislg...
|22
|4552
|493
Evaluation Methods for Investment Decision Making - Business Case Study 2lg...
|7
|1513
|465
Internal Rate of Return and Capital Appraisal Techniques Analysislg...
|5
|721
|110
Capital Budgeting Analysis of ‘Real Time Translator’ project of Auditizz Electronicslg...
|10
|2053
|64
Financial Analysis for Hotels Assignmentlg...
|6
|1102
|33