Evolution of IRR Homework Help

Evolution of IRR

The IRR method is a theoretically correct technique to evaluate capital expenditure decisions. II has the advantages which are offered by the NPV criterion such as:.(j) it considers the time value of money. and (ii) it takes into ‘account the total cash inflows and outflows. In addition. the IRR is easier to understand. Business executives and non-technical people understand the concept of IRRmuch more readily than they understand the concept of NPV. They may not be following the definition of IRR in terms of the equation but they are well aware of its usual meaning in terms of the rate of return on investment. For instance. business executives. will understand the investment proposal in a better way if told that IRR of machine B is 21 per cent and k is 10 per cent instead of saying that the NPV of machine B is Rs 15.396. Another merit of IRR is that it does use the concept of the required rate of rerun the cost of capital. It itself provides a rate of return which is indicative of the profitability of the proposal. The cost of capital. of course, enters the calculations later on. Finally, it is consistent with the overall objective of maximizing  shareholders’ wealth. At:cording to IRR, as a decision-criterion, the acceptance or otherwise of a project is based on a comparison Qf the IRR with the required rate of return. The required rate of return is. by definition, the minimum rate which investors expect on their investment. In other words. if the actual IRR of an investment proposal is equal to the rate expected by the investors. the share prices will remain unchanged. Since. with IRR,only such projects are accepted as have IRR required rate, the share prices will tend to rise. This w~1 naturally lead to the maximization of shareholders’ wealth. Its theoretical soundness notwithstanding, the IRR suffers from serious limitations. First, it involves tedious calculations. As shown above. it generally involves complicated computational problems. Secondly, it produces multiple rates which can be confusing. This aspect is further developed later in this chapter. Thirdly, in evaluating mutually exclusive proposals. the project with the highest IRR would be picked up to the exclusion of all others. However, in practice, it may not turn out to be the one which is the most profitable and consistent with the objectives of the firm. that is. maximization of the shareholders’ wealth. This aspect also has been discussed in detail later in “this chapter. Finally, under the IRR method. it is assumed that all intermediate cash flows are reinvested at the IRR. In our example. the IRR rates for machines A and Bare 17.6 per cent and 20.9 per cent respectively. In operational terms. 17.6 per cent IRR Signifies that all cash inflows of machine A can be reinvested-at 17.6 per cent whereas that of B at 20.9 per cent. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates, There  is no difference in’ the ‘quality of cash’ received either from’ project A or B. The reinvestment rate assumption under the 1 M method is, therefore, very unrealistic. Moreover, it is not safe to assume always that intermediate cash flows from the project will be reinvested at all. A portion of cash inflows may be paid out as dividends. Likewise, a portion of it may be tied up in current assets such as stocks, debtors or cash. Clearly, the firm will get a wrong picture of the capital project if it assumes’ that it invests the entire intermediate cash proceeds, Further, it is not safe to assume, as is often done. that they will be reinvested at the same rate of return as the company is currently earning on its capital (IRR) or at the current cost of capital. k. In order to have correct and reliable results it is obvious, therefore, that they should .be based on realistic estimates of the interest rate Of any) at which income will be reinvested. Effeminate value takes care of this aspect.

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