Internal Rate of Return (IRR) is also known as Time-adjusted rate of return. IRR is the rate at which NPV becomes zero. In other words, we could say that IRR is the rate at which present value of cash inflows and present value of cash outflows will be equal.
In this technique, unlike net present value, we are not given a discount rate. The discount rate is ascertained by trial and error.
Important thing to remember:
- This method is based on trial and error. We should keep in mind that we need two rates, one rate higher to PV Factor and another rate lower to PV factor. Then we need to calculate NPVs at those rates. NPV at one rate should be negative and NPV at one rate should be positive.
- We should also keep in mind
- Lower the rate, higher the NPV
- Higher the rate, lower the NPV
- Suppose NPV is Negative at 10% discount rate. Now, we need another NPV which should be Positive. So, going by the above rule, we should calculate NPV at some rate which is lower to 10%.
- If two rates are given in the question, we simply need to calculate the NPV at both the rates and apply those values in the formula. (This is much better haha)
Merits of IRR
- It takes into account time value of money. Thus, cash inflows occurring at different time interval are adjusted with the appropriate discount rate.
- It is a profit oriented concept and helps in selecting those proposals which are expected to earn more than minimum required rate of return.
- In IRR all cash flows are considered including working capital used and released, salvage value is also considered.
- It is based on cash flow.
- It involves complicated trial and calculation.
- It makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to IRR. This assumption is not true as the firms are able to reinvest only at a rate available in the market.
- Many times it may yield multiple rates.