Importance Of Internal Rate Of Return In Capital Investment Decisions

Capital Finance Evaluation Methods

When any decision regarding the capital expenditure has been made in the organization, the management wants to know that what the whole project will cost and what return that project will give if it has been selected. Management always wants to select such investment proposals that provide maximum profits and returns with minimal risks from the available list of mutually exclusive investment projects. In order to determine the best capital expenditure proposal, project and portfolio of the desired investments, there are several capital finance evaluation methods available that can be used by the management to choose the best project from the available project list. Management can rely on such capital investment evaluation methods in order to decide the acceptance and rejection of the project. Some of the commonly used capital investment evaluations methods are pay back method, accounting rate of return, net present value and internal rate of return. Among all these methods internal rate of return is the most common and also important methods that is used by the potential investors to decide whether to take up the investment in particular or not.

Capital investment decisions are regarded as the most important decisions that are taken by the management to earn the maximum return with minimum risk. The main goal of the capital investment decisions is to increase the value of firm as the substantial cash outlays are involved and these decisions if once implemented that it cannot be reversed.

In this essay there will be discussion regarding the importance of the internal rate of return method and how the IRR is the useful indicator of the potential project performance even if there is no capital rationing. Numerical examples are used to evaluate this statement and to support the findings.

The internal rate of return (IRR) has been defined as the interest rate or percentage of the discount rate where the project will be going to break even. So it can said that IRR of any project refers to such rate of return that equal the cash flows form the project to zero. In other words it can be said that it provides that interest rate if used as the discount rate or cost of capital in calculating the net present value will give answer as zero. It can be said that internal rate of return provides the information about the return that project will provide if that project is implemented. In financial term it can be understand as the financial metric of cash flow that is primarily used for the project appraisal, project evaluation, project proposal analysis and capital acquisition decisions (Bromwich and Bhimani, 2005). The internal rate of return can be simply understood from this equation: NPV = ∑ [CF_t / (1 + IRR) t] =0, where, CF_t represents the cash flow at time t. Here, NPV is given the value zero because if the calculated IRR rate used for discount cash flows than certainly it will be zero as at this value the project is providing the returns to the company. So, it can be said that by sampling calculating the internal rate of return one can judge whether the project is useful for the investment point of view of not. If the IRR is lower than the cost of capital to the company than it is costlier for the management, but if the IRR is gather than the cost of the capital than such project can be accepted as it is increasing the shareholders value (Brealey, Myers and Marcus, 2007).   

Importance of the Internal Rate of Return and Why It’s Different from Other Methods

Importance of the internal rate of return and why it is different from other methods

All capital budgeting methods are used to evaluate the performance of the potential investment projects but IRR is most successful indicator for evaluating the investment appraisal. There are numerous advantages that made it important and different from others. Firstly it must be note that internal rate of return method is based on the time value of money so all the cash flows are discounted that desired interest rates so that IRR can be computed. Discounting the cash flows to the present values helps to give equal weight to all the future cash flows. IRR is easy to measure and it provides useful means to evaluate the projects that are under consideration. Using the IRR method to decide which project has to be selected from the available projects, it proves to very useful as it make it very easy to compare. The most important advantage that makes it different from others while making the calculation for the internal rate of return there is that there is no requirement of cost of capital or discount rate whereas in rest of methods there is requirement of cost of capital in order to make calculation (Damodaran, 2011). The cost of capital is discount rate that is fixed by the management for the capital rationing purpose. So it can be said that IRR can be used without the decisions of capital rationing for evaluating the potential projects. Internal rate of return does not give emphasis to the capital rationing decisions made by the company as this method is truly based on the assumptions that every project provides some return and through using that rate of return projects can be compared with one another. IRR is vey useful as compared to NPV method as NPV considered various factors such as taxation rate, depreciation expenses, and cost that arises in future while IRR clearly ignores all such factors aim of the IRR is to calculate the rate of return where the NPV is zero. Using IRR as the method of evaluation one can compare all the projects that are under consideration without even using the capital rate decided by the management for evaluation purpose (Davies and Crawford, 2011).

There are various capital budgeting methods used by the business enterprises for evaluating the potential worth of an investment. The management of a business company has to take decisions regarding the selection of the most profitable business project through examining the risk level. The various techniques for examining the potential worth of an investment used by a business are NPV (Net Present Value), IRR (Internal Rate of Return), payback period, ARR (Accounting Rate of Return) and many others. The IRR is regarded to be most used technique for evaluating the performance of a project. The method helps in determining a rate at which a project is able to attain its break-even point that is the situation of no profit or loss by a business entity. This is the rate of return at which the present value of cash inflows is equal to the value of outflows of cash (Brigham and Ehrhardt, 2007).

Internal Rate of Return and Capital Budgeting

The project manager accepts a project on the basis when the IRR is greater than the capital cost and vice-versa. The business managers largely adopt the use of IRR for taking decisions related to capital budgeting as it is an objective method in comparison to other methods. The method is also relatively easy to understand and implement even by the people having little knowledge of finance. This is because the method only uses a single discount rate for analyzing the potential worth of an investment. On the other hand, the other methods of capital budgeting such as NPV are highly complex to understand and apply by a project manager. The method can be used by business organizations for examining a project performance and taking decision regarding the amount of capital to be invested in a project even if there is no capital rationing (Petty et al., 2015).

The capital rationing refers to imposing restrictions on the amount of new investments undertaken by a company due to budget constraints. This can be done by the businesses by placing higher cost of capital when the expected returns attained from a project are less than that expected. The business organizations incorporates the use of capital budgeting techniques such as NPV and IRR to allocate the funds available to different project options that are expected to provide maximum profitability. Therefore, the method of capital budgeting are extremely important for businesses in gaining a selection of a project that will provide the best results in the condition of capital constraints (Megginson, 2008). 

However, the method of IRR can be used by a project manager to examine the potential performance of a project even if there is no capital rationing. This is due to the simplicity of the method that enables the business managers to use at any time without any constraints. The net cash flows realized by a project selected through the use of IRR technique are re-invested at the same or higher IRR to generate larger returns in the future. The results obtained from the method can be easily interpreted by the business mangers and thus evaluating the potential worth of an investment (Megginson, 2008). For example, if the IRR calculated for a project is 15% and the hurdle rate is 10%, it clearly indicates that investors can gain 5% returns on the capital invested. As such, the higher IRR of a project indicates its more desirability to be undertaken by a business manager. Thus, if a business manager has different project options each requiring similar investments then the project with highest IRR should be accepted even if there is no capital rationing. Also, the method takes into account the concept of time value of money and therefore can be regarded to be highly reliable in predicting the future worth of an investment (Drury, 2004).

Limitations of the Internal Rate of Return Method

The method is highly intuitive and therefore will improve one’s ability to analyze the potential investments. As such, the business managers are recommended to incorporate the use of the technique of IRR for taking capital budgeting decisions to increase their skills related to taking decisions for selecting a viable project option. However, there are some drawbacks of the method that limits its application in the capital budgeting decision to some extent. The major issue of concern related with the use of method is that it is not highly useful in comparing the internal rate of return to the cost of capital as there is not an accurate calculation of IRR. There may be computation of different IRR’s and as such comparison of IRR with the cost of capital is difficult. Also, the method is not reliable if there is not an accurate prediction regarding the cost of capital and it changes over a period of time. The feasibility of project having different cash-flows at varied discount rates cannot be calculated accurately through the use of IRR method. Therefore, there are some limitations of the method in relation to evaluating a project performance (Chary, 2009).

Despite of these limitations, the method is most commonly used for evaluating the potential worth of an investment due to is simple nature. The method provides a simple evaluation of a project worth that supports the decision-making process of management of capita; investment. Also, the use of the modified internal rate of return (MIRR) has helped the business managers to overcome from the problems faced during the use of IRR method. The financial method of MIRR can be used in the capital budgeting decisions for analyzing the potential performance of projects having multiple cash-flows. The method has also helped in overcoming the assumption of the IRR method that cash flows realized should be re-invested at the same rate of return which is often unrealistic. The MIRR method uses the basis of the weighted average cost of capital for considering the decision related to re-investment of the cash flows realized from a proposed project investment. In addition to this, the problem associated with the use of IRR of computing multiple IRR’s for projects having positive and negative cash flows is effectively overcome by the method of MIRR. The method of MIRR computes only one value of internal rate of return thus providing an accurate rate of return to be compared with cost of capital during investment decisions (Baker and English, 2011). 

The method of IRR is regarded to be a popular method used for taking investment decisions as it is simple to be used and is also not time-consuming. Thus, the practitioners, finance officers, managers can analyze the potential worth of their investments through the use of method even if there is no capital rationing. The method of NPV is mainly sued by businesses in the situation of capital rationing when there is need of selecting the bets project option for capital investment due to presence of capital constraints. As such, of there is no capital rationing it is highly advised to businesses to incorporate the use of IRR method for project evaluation so that accurate decisions can be taken for ensuring the business growth in future context (Petty et al., 2015).

These are two projects that are under consideration by the management of the company. Both these projects will be evaluated using the NPV and IRR methods and differences are noted in order to explain why IRR does not consider the capital rationing decisions.

Years	Particulars	Project A	Project B
		Machine 1	Machine 2
1-Jan-17	Initial Investment	$ (160,000.00)	$ (170,000.00)
31-Dec-17	Cash Inflow	$      61,000.00	$      21,000.00
31-Dec-18	Cash Inflow	$      61,000.00	$      31,000.00
31-Dec-19	Cash Inflow	$      61,000.00	$      41,000.00
31-Dec-20	Cash Inflow	$      51,000.00	$      71,000.00
31-Dec-21	Cash Inflow	$      51,000.00	$      81,000.00
31-Dec-22	Cash Inflow	$      41,000.00	$      61,000.00
31-Dec-22	Residual Value	$                     –	$      20,000.00

Here as the capital rationing decision, cost of capital is taken as 20%

Particulars	PVF @ 20%	PV of Project A @ 20%	PV of Project B @ 20%
31-Dec-17	0.833	£50,833.33	£17,500.00
31-Dec-18	0.694	£42,361.11	£21,527.78
31-Dec-19	0.579	£35,300.93	£23,726.85
31-Dec-20	0.482	£24,594.91	£34,239.97
31-Dec-21	0.402	£20,495.76	£32,552.08
31-Dec-22	0.335	£13,730.82	£20,428.78
Residual Value	0.335	£0.00	£6,697.96
Present Value of Cash Inflows	£187,316.85	£156,673.42

Particulars	Project A	Project B
Present value of cash Inflows	£187,316.85	£156,673.42
Present value of cash outflows	£160,000.00	£170,000.00
NPV	£27,316.85	£13,326.58

Particulars	PVF @ 15 %	PV of Project A @ 15%	PVF @ 35 %	PV of Project A @ 35%
31-Dec-17	0.870	$                       53,043.48	0.741	$                       45,185.19
31-Dec-18	0.756	$                       46,124.76	0.549	$                       33,470.51
31-Dec-19	0.658	$                       40,108.49	0.406	$                       24,792.97
31-Dec-20	0.572	$                       29,159.42	0.301	$                       15,354.48
31-Dec-21	0.497	$                       25,356.01	0.223	$                       11,373.69
31-Dec-22	0.432	$                       17,725.43	0.165	$                         6,773.00
Residual Value	0.432	$                                      –	0.165	$                                      –
Total		$                     211,517.59		$                     136,949.83
NPV		$                       51,517.59		$                     (23,050.17)
IRR of Project A	28.82%
Particulars	PVF @ 15 %	PV of Project B @ 15%	PVF @ 35 %	PV of Project B @ 35%
31-Dec-17	0.870	$                       18,260.87	0.741	$                       15,555.56
31-Dec-18	0.756	$                       23,440.45	0.549	$                       17,009.60
31-Dec-19	0.658	$                       26,958.17	0.406	$                       16,664.13
31-Dec-20	0.572	$                       40,594.48	0.301	$                       21,375.84
31-Dec-21	0.497	$                       40,271.32	0.223	$                       18,064.09
31-Dec-22	0.432	$                       26,371.98	0.165	$                       10,076.91
Residual Value	0.432	$                         8,646.55	0.165	$                         3,303.90
Total		$                     184,543.82		$                     102,050.03
NPV		$                       14,543.82		$                     (67,949.97)
IRR of Project B	18.53%

In IRR it can be seen that there is no use of cost of capital while making the calculations 

Conclusion

Thus, it can be stated from the overall discussion held in the report that capital budgeting decisions are very important in business context for ensuring its sustained growth and development. There are various capital budgeting techniques that are used by business mangers for evaluating the potential worth of an investment. The IRR method is most used for investment decisions due to is intuitive and simple nature. The method can be easily applied and also leads to improving the ability of business managers in selecting feasible project options. Thus, the method is largely used by the business people and practitioners for analyzing the potential worth of different investment options even if there is no capital rationing. The use of various numerical examples in the report has also helped in developing a better understanding of the method of IRR. 

References

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Megginson, W. 2008. Introduction to Corporate Finance. Cengage Learning EMEA.

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Baker, H. and English, P. 2011. Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. John Wiley & Sons.

Petty, W. et al. 2015. Financial Management: Principles and Applications. Pearson Higher Education AU.

Brealey, R., Myers, S.C. and Marcus, A.J., 2007. FundamentalsofCorporate Finance. Mc Graw Hill, New York.

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