Redeeming Qualities of the IRR

Despite its flaws, the IRR is very popular in practice, more so than even the NPV. It probably survives because it fills a need that the NPV does not. In analyzing investments, people in general, and financial analysts in particular, seem to prefer talking about rates of return rather than dollar values.

In a similar vein, the IRR also appears to provide a simple way of communicating information about a proposal. One manager might say to another, "Remodeling the clerical wing has a 20 percent return." This may somehow seem simpler than saying, "At a 10 percent discount rate, the net present value is $4,000."

Finally, under certain circumstances, the IRR may have a practical advantage over the NPV. We can't estimate the NPV unless we know the appropriate discount rate, but we can still estimate the IRR. Suppose we didn't know the required return on an investment, but we found, for example, that it had a 40 percent return. We would probably be inclined to take it because it would be very unlikely that the required return would be that high. The advantages and disadvantages of the IRR are summarized as follows.

Advantages and Disadvantages of the Internal Rate of Return

Advantages

Disadvantages

1. Closely related to NPV, often leading to identical decisions.

2. Easy to understand and communicate.

1. May result in multiple answers or not deal with nonconventional cash flows.

2. May lead to incorrect decisions in comparisons of mutually exclusive investments.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria

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CHAPTER 9 Net Present Value and Other Investment Criteria

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