Definition of IRR

The discount rate often used in capital budgeting that makes the net present value of
all cash flows from a particular project equal to zero. Generally speaking, the higher a
project's internal rate of return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)

WHY NPV IS BETTER THAN IRR :-

1) One way to understand the preference of NPV over IRR, more

generally, is to recognize that NPV uses the “correct” rate, i.e., the cost
of capital, to discount the cash flows, rather than an “arbitrary” rate,
i.e., the IRR, that makes NPV =0.

2) Another way to understand the superiority of the NPV rule is that the
discounting process inherent in both the IRR and NPV techniques
implicitly assumes the reinvestment of the cash flows at whatever
discount rate is used, either IRR or the cost of capital. When the IRR is
very high relative to the cost of capital it is unrealistic to assume
reinvestment at that high rate. This is especially damaging when
comparing
two investments with very different timing of cash flows. We will revisit
this reinvestment assumption later, under our discussion of yield to
maturity on coupon bonds, where its meaning will become clearer.

3) NPV is better than IRR because a postive NPV indicates addition to shareholder's
wealth and negative NPV indicates vie versa. This thumb rule cannot be applied to
IRR.

4) Term structure of interest rates raises bigger problems for IRR than NPV

ADVANTAGE NPV DIS ADVANTAGE NPV

It will give the correct decision advice It is very difficult to identify the correct
assuming a perfect capital market. It will discount rate.
also give correct ranking for mutually
exclusive projects.
NPV gives an absolute value. NPV as method of investment appraisal
requires the decision criteria to be
specified before the appraisal can be
undertaken.
NPV allows for the time value fo the cash Requires an estimate of the cost of capital
flows. in order to calculate the net present value
Tells whether the investment will Expressed in terms of dollars, not as a
increase the firm's value. percentage.

Considers all the cash flows With the NPV method, the disadvantage
is that the project size is not measured
Considers the time value of money
Considers the risk of future cash flows
(through the cost of capital)

With the NPV method, the advantage is

that it is a direct measure of the dollar
contribution to the stockholders.

Internal Rate of Return

Advantages

• Tells whether an investment increases the firm's value

• Considers all cash flows of the project
• Considers the time value of money
• Considers the risk of future cash flows (through the cost of capital in the
decision rule)
• With the IRR method, the advantage is that it shows the return on the original
money invested.

Disadvantages

• Requires an estimate of the cost of capital in order to make a decision

• May not give the value-maximizing decision when used to compare mutually
exclusive projects
• May not give the value-maximizing decision when used to choose projects
when there is capital rationing
• Cannot be used in situations in which the sign of the cash flows of a project
change more than once during the project's life .
• With the IRR method, the disadvantage is that, at times, it can give you
conflicting answers when compared to NPV for mutually exclusive projects.
The 'multiple IRR problem' can also be an issue.