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Merits and demerits of using IRR as an investment evaluation method
Internal Rate of Return (IRR) is a popular investment evaluation method, as it offers the profitability of a project in percentage terms. The IRR criterion is also popular because it can be easily compared with the opportunity cost of capital. However, like all other investment evaluation methods, it also has some merits and demerits.
Merits of IRR Method
Following are the merits of using IRR as an investment evaluation method −
Time value of money − IRR considers the time value of money. It states that a rupee today will be worth more than a rupee tomorrow. By considering the time value of money, IRR makes a correct assumption about profitability. In fact, IRR saves enough wealth by considering the time value of money.
Measurement of profitability − IRR considers all cash flows to correctly measure the profitability of an investment proposal. This provides a comprehensive measurement of profitability as future cash inflow and outflow estimates are considered. By including cash flow features, IRR takes the view of the entire life of a project to measure profitability in the long-term future.
Increase in Shareholders’ value − IRR aims to maximize the shareholders’ wealth by considering all aspects related to shareholders’ wealth maximization rules. It is by large one of the most promising features of IRR because every investment needs to prioritize shareholders’ wealth creation and maximization.
Demerits of IRR Method
Following are some of the demerits of using IRR as an investment evaluation method −
Multiple Rates of Return − According to IRR, an investment project may have different and multiple rates of return. Having more than one rate not only increases the complexity of the calculation, but it also creates a dilemma where choosing the best project becomes critical. Therefore, having multiple rates of returns is one of the prominent demerits of IRR.
Failing to identify the best project in case of mutually exclusive ones − IRR may fail to identify the best project if there are mutually exclusive projects on the horizon. Not being able to identify the better project means there may be large losses in the future for which IRR estimation becomes flawed and non-competitive in nature.
Value additivity does not hold good − Unlike NPV, value additivity doesn’t hold good for IRR. This means that the IRR for a larger project need not be equal to the sum of all smaller subsidiary projects. In addition of smaller projects’ IIRs are incapable to produce the IRR of the larger project, it is not possible to calculate the value of IRR of the larger projects even if we know the smaller IRRs. This creates a big issue in applying and calculating IRRs in both theory and practice.
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