Internal Rate of Return of a project is a discount rate at which the net present value of a project is zero. In case of several independent projects, a project where IRR is greater than the cost of capital shall be accepted and in case of mutually exclusive projects, the project with a highest IRR shall be selected. It is also known as realized rate of return. (K.J.S. Satyasai)
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Net present value indicates the impact of a projects value on firm’s value. The projects with a positive NPV shall be selected and those with a negative NPV shall be rejected & not to be undertaken. In case of mutually exclusive projects, the project with a largest NPV shall be selected. NPV is computed as the difference between the present value of the project cash inflow and the present value of the project cash outflow.
Capital budgeting is a process by which firm decides among the various long term projects which project is to be undertaken. The factors to be considered while deciding various projects is the cash flows generated from the project and the cost related to that project.
How to Calculate
IRR measures the growth of the portfolio in absolute terms. To compute internal rate of return, we should use either trial & error method or average capital base.
Trial & error method
This method requires certain information for the time under consideration
All inflows of capital for the project.
All outflows of capital for the project.
The beginning value of the project at beginning of the computation period.
The ending value of the project at end of the computation period.
PV = Sum of (FVi / (1+r) ni) + FVe / (1+r) N
Where, PV represents the present value, FVi represents future cash flow i, ni represents number of period i, r is IRR, FVe is end value and N represents the number of period.
Average capital base method
IRR = (End Value – Begin Value – Total Contributions + Total Withdrawals) / (Begin Value + Total Weighted Contributions – Total Weighted Withdrawals)
Where
Total Weighted Contributions – Total Weighted Withdrawals = Sum of (Each Change in Capital Xi (Days Left in Period for Xi / Total Days in Period))
Advantages and Disadvantages of IRR
Advantages:
It takes into consideration the time value of money while evaluating a project as compared to ARR method (Accounting Rate of return) which does not takes it into consideration.
This method is simple to interpret as compared to other methods.
It does not require to compute hurdle rate or required rate of return.
The required rate of return is a rough estimate and IRR is not completely based on required rate of return.
Disadvantages:
It ignores the actual dollar value of benefits.
Assumes that the project will generate future cash flow which is reinvested at IRR. If a project generates low IRR, then it will assume reinvestment at low rate of return and on the other hand if the other project has very high IRR, it will assume reinvestment rate at very high rate of return. But this is not a realistic situation. As at the time the cash flows are generated, will have same investment opportunities is very difficult.
In case of certain projects, a manager may require to invest into certain contingent projects also. So, IRR ignore these additional costs. IRR may suggest to purchase a asset but the benefits derived from that project may be wiped off by the cost of the contingent project.
In case of mutually exclusive projects, that is the manager if selects then he has to reject other projects. In such a case IRR is not suitable as it gives a percentage of interpretation value which is not sufficient.
It does not take into consideration the duration of a project in case two projects are evaluated with different time period.
Other competitive methods
Pay Back Period (Investment appraisal techniques, The Institute of Chartered Accounts England and Wales)
Refers to time required for cash generated from a project to become equal to the initial cash outflows. This method is an initial screening method where by a manager can determine the initial time period by which projects return would equate the cost invested in a project. Hence, it would reject a project whose payback period is more than the targeted payback period. This method is very simple to use. It enhances the liquidity by focussing on early pay back.
This method is alone is not suitable to determine the real worth of a project as it has several disadvantages:
Ignores the timing of cash flows with the payback period.
Ignores the cash flows after the end of an project as well as the total return of a project
Also ignores the time value of money.
In case two projects has similar payback period then it is difficult to determine which method is suitable.
It could also lead to excessive investment in short run.
It takes into account the risk of the timing of cash flows but does not take account of the variability of the cash flows.
Accounting Rate of Return (Investment appraisal techniques, The Institute of Chartered Accounts England and Wales)
ARR is defined as the average accounting period as a percentage of the accounting outlay. Higher the ARR better it will be. In order to select a project, ARR should be above the minimum acceptable level. The main advantage of the project is that it is very simple to calculate and understand. But it has several disadvantages:
It does not take into consideration the timing of the project.
It is subject to various accounting policies as it is based on accounting profits rather than cash flows.
It ignores the time value of money.
It does not take into account the size of an investment as it is a relative measure rather than absolute measure.
Net Present Value (Investment appraisal techniques, The Institute of Chartered Accounts England and Wales)
The difference between present value of future cash flow of an investment and the amount of an investment. Discounted cash flow (DCF) techniques discount all the forecast cash flows of an investment proposal to determine their present value. The main advantage of this methodology is that it takes into consideration the time value of money. If NPV is positive, it indicates cash inflows from a project will generate a return more than the cost of capital hence the project shall be undertaken. If NPV is negative then it indicates that the inflows from a project would generate a return lower than the cost of capital, hence the project shall not be undertaken. If NPV is zero then it indicates that the cash inflows from a project would generate return same as the cost of investment, hence the project should not undertaken as it would have certain inherent risk and will not generate any wealth to the shareholder. Disadvantages:
The project size could not be measured or is not reflected.
It is difficult to compute.
It is difficult to compute appropriate discount rate.
It may not give appropriate result when projects have unequal span of life.
Time Value of Money
Time Value of Money (TVM) is based on the principle that money is available at the present time is worth more than the same amount in the future due to its potential earning capacity. It is an important concept in financial management and can be used to compare investment alternatives.
The drivers of time value of money are inflation, consumer preferences and risk.
The concept has an impact on the appraisal of long term projects. So, the future cash flows are discounted to reflect the time value of money. The total of these discounted cash flows reflect the true value of a project.
Disadvantages
This method requires an estimate of the cost of capital to decide a project.
In case of mutually exclusive projects, the method does not give value maximizing decision.
In case of capital rationing it does not give value maximizing decision.
This method cannot be used in situation where the sign of cash flow during a project more than once during the life of a project.
Conclusion
IRR is an appropriate method to select a project as it considers the time value of money. As in today’s world of competition, inflation plays a very significant role which decreases the value of money over a period of time. So, by considering these factors it becomes one of the methods while evaluating a project.
Recommendations
Each method has its own advantages and disadvantages so a manager should be very careful while selecting an appropriate methodology. If a manager chooses a wrong methodology then he would end up selecting a wrong project and can incur heavy losses.
Appendix
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