15.10 Discounted cash flow methods: internal rate of return

Question 1

What does internal rate of return (IRR) calculate?

Answer 1

The rate of return at which the NPV of all the cash flows from a project or investment is zero - i.e. the discount rate that allows the project to break even.

Question 2

What is the decision rule for appraisal of projects using the internal rate of return (IRR) method?

Answer 2

A project should be accepted if IRR is greater than the cost of capital.

Question 3

What are the advantages of appraisal of projects using the internal rate of return (IRR) method?

Answer 3

• IRR method evaluates potential returns and the attractiveness of investments
• takes accounts for the time value of money
• easier for management to understand than the concept of NPV

Question 4

What are the disadvantages of appraisal of projects using the internal rate of return (IRR) method?

Answer 4

• ignores key factors such as project duration, future costs, etc.
• does not measure the actual size of investments/returns, only whether the investment is profitable (so a huge investment with small return would appear favorable using IRR when this might not actually be the case).
• the most complex method of appraisal
• it assumes that future cash flows are reinvested, but this may not be realistic.