Internal Rate of Return:
The internal rate of return (IRR) is another useful capital budgeting technique. Like NPV it takes into account the time value of money and it uses cash flows not accrual profits. IRR is the discount rate at which the NPV of the project would equal zero. For example the NPV of investing $100 now and receiving $110 in one year’s time would be 10%. If we discounted this stream of cash flows at 10% the NPV = 0.
How is it used?
Once the IRR of a project is determined it is simply compared with the actual discount rate.
If IRR > discount rate we accept the project
If IRR < discount rate we do not accept the project
Why is it used?
IRR takes into account:
1) All cash flows
2) The time value of money
3) It is very simple to understand
4) Aids in comparability between projects, especially projects with different initial investments
NPV vs IRR
NPV is regarded as more ideal because:
1) It is more useful in certain situations (beyond the scope of this course)
2) IRR simply gives a percentage while NPV actually tells you how much value it will add. For example we may have two projects with an IRR of 10%. But at a discount rate of 12% the NPV of one project may be $200 while the other $1,000. Quite clearly the second project would add more value