There are numerous techniques of evaluating an investment which might be typically used by managers in both personal corporations and public corporations. Every of these measures is meant to be a sign of profit for a project or investment. Some of these measures imply the scale of the profit at a particular point in time; others provide the rate of return in line with period while the capital is in use or when reinvestments are included. This section of the essay will discuss the internal rate of return (IRR), payback period (PBP) and the net present value (NPV) approaches for a project evaluation.
The internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate regularly utilized in capital budgeting that makes the net present value of all cash flows from an investment equivalent to 0, meaning IRR is the rate of return that makes the sum present value of future cash flows and the final market value of a project (or investment) equals its current market value. The higher a project’s internal rate of return, the extra desirable it is to adopt the investement or project.
Ross (2013) calls IRR, the most important alternative to NPV and Graham (2001) said its the most used measure for evaluating projects. Graham (2001) claims that in 2001 75,6 percent of CFOs use the IRR method when comparing and deciding between capital projects. “The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project” (Ross 2013). “It doesn’t depend on anything except the cash flows of the project, because the number is internal or intrinsic.”
“The internal rate of return is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equals zero” (investinganswers.com link). It is pretty similar to the NPV formula:
When calculating the IRR one has to use goal-seeking to find which rate that will make NPV equal to zero. This can be done through linear interpolation or trail and error, where you simply choose two values, one high and one low and eventually work you way to finding the value between them that makes NPV equal to zero. This can also be done in Excel (Marney, 2011).
Irr can be mathematically calculated using the formula:
C0 – the cash outflow generated in length No= zero
C – the cash flow generated in the particular duration (the last duration being ‘n’).
Irr, denoted via ‘r’ is to be calculated with the aid of employing trial and blunders method or use built-in functions from excel.
Similarly to troubles related to calculating an irr, there are a few issues with which the person have to be aware. One in all them, if the series of cash flows has more than one sign reversal, then there are more than one solutions. For instance, if we’ve got two sign changes within the series of cash flows and for this reason we’ve got double irrs.
Actually, there are as many roots (solutions) as there are modifications in signs and symptoms, so a trouble with four sign reversals could have four different solutions. To deal with this difficulty, a modified internal rate of return, or mirr, is regularly used.
There are several advantages when it comes to the IRR. But the main aspect is that it provides a need that NPV doesn’t; a rule that summarizes the information of a project in a single rate of return. A big plus is that it takes the TVM into consideration unlike the payback period method. After calculated, it is very simple to interpret and therefor easy to visualize for managers.
The main disadvantage is that the economies of scale are ignored. A project value of £1,000,000 with a 20 percent rate of return would naturally be preferred over a project value of £1,000 with a 40 percent rate of return. But with the latter rank of the IRR method would advise otherwise as 40 percent is more than 20 percent. This problem usually occurs specifically to mutually exclusive projects and can be solved for example using incremental cash flows. A second disadvantage is one that arises when there are conventional cash flows. In those cases the NPV will equal zero more than one time, which will lead to multiple IRRs. In these cases the IRR method simply cannot be used here.
A third disadvantage to the IRR method is that it has impractical implicit of the reinvestment rate. Even though it is rarely the case where a firm has the same reinvestment rate, the IRR method implies this. It continues to assume that the firm will make another investment at the same rate even though that is close to impossible.