Internal Rate of Return

Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero.

NPV and IRR methods will always result identical accept/reject decisions for independent projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects.

The problem with IRR come about when Cash Flows are non-conventional or when we are looking for two projects which are mutually exclusive. Under such circumstances IRR can be misleading.

Suppose we have to evaluate two mutually exclusive projects. One of the project requires a higher initial investment than the second project; the first project may have a lower IRR value, but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint).

Decision Rule of Internal Rate of Return:

If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted or should be rejected otherwise.