What are the major disadvantages of the use of the internal rate of return method of analyzing capital investment proposals?

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In capital budgeting, there are a number of different approaches that can be used to evaluate a project. Two very common methodologies of evaluating a project are the internal rate of return and net present value. However, each approach has its own distinct advantages and disadvantages. Here, we discuss the differences between the two and the situations where one method is preferable over the other.

Key Takeaways

• Both IRR and NPV are useful to determine what projects to accept and what profitability a company can expect.
• The internal rate of return estimates the outcome of a project by analyzing cash flow and reporting an expected percent return.
• While the internal rate of return is simple to calculate and understand, it's not useful for analyzing projects with multiple periods of cash outflow or multiple discount rates.
• The net present value estimates the outcome of a project by adding all discounted cash flows together to report a single positive or negative dollar amount.
• Though the net present value method is more flexible, it isn't useful when trying to compare projects of different sizes or analyze a project's return timeline.

Capital Budgeting: Which is Better, IRR or NPV?

What Is IRR?

The internal rate of return (IRR) estimates the profitability of potential investments using a percentage value rather than a dollar amount. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes external factors such as capital costs and inflation.

The IRR method simplifies projects to a single return percentage that management can use to determine whether or not a project is economically viable. A company often has an internal required rate of return to benchmark against and may decide to move forward with a project if the IRR exceeds this benchmark. On the other hand, a company may want to reject a project if it falls below that rate or return or it projects a loss over a period of time.

IRR Pros and Cons

The IRR is simple to use and does not require a hurdle or benchmark rate. However, it ignores the size of a project,

What Is NPV?

Unlike the IRR, a company's net present value (NPV) is expressed in a dollar amount. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.

NPV is calculated by estimating a company's future cash flows related to a project. Then, these cash flows are discounted to present value using a discount rate representing the project's capital costs, risk, and desired rate of return. The sum of all discounted cash flows represents the net present value, and the net present value is the difference between the project cost and the income it generates over time.

NPV Pros and Cons

NPV is easy to interpret: if the NPV is positive, it is profitable. If the NPV is negative, it is not. However, NPV isn't useful when trying to decide which projects to take on as size or timeline aren't considered.

Problems With IRR

The primary benefit of IRR is its simplicity: It's easy to calculate and easy to interpret the result. However, there are several drawbacks to this method.

IRR only uses one discount rate, and the true discount rate can change substantially over time - especially if the investment is a long-term project. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with periods of varying risk or changes in return expectations. 

Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which the marketing department must reinvent the brand every couple of years to stay current in a trendy market.

The project has cash flows of:

• Year 1 = -$50,000 (initial capital outlay) 
• Year 2 = $115,000 return
• Year 3 = -$66,000 in new marketing costs to revise the look of the project.

A single IRR can't be used in this case. Recall that IRR is the discount rate or the interest needed for the project to break even given the initial investment. If market conditions change over the years, this project can have multiple IRRs. In other words, long projects with fluctuating cash flows and additional investments of capital may have multiple distinct IRR values, making it impossible to evaluate.

The IRR method is also problematic when the discount rate of a project is not known. If the IRR is above the discount rate, the project is feasible. If it is below, the project is not. If a discount rate is not known, there is no benchmark to compare the project return against. In cases like this, the NPV method is superior as projects with a positive NPV are considered financially worthwhile. 

Using NPV

The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple discount rates or varying cash flow directions. Each year's cash flow can be discounted separately from the others, so the NPV method is more flexible when evaluating individual periods. The NPV method is inherently complex and requires assumptions at each stage such as the discount rate or the likelihood of receiving the cash payment. 

The NPV can be used to determine whether an investment such as a project, merger, or acquisition will add value to a company. If an NPV is positive, the sum of discounted cash inflows is greater than the sum of discounted cash outflows. The company will receive more economic benefit than it puts out, so the project, assuming the return is material and no capacity constraints are met, is beneficial to the company.

Alternatively, a negative NPV indicates a company's cash outflows over the life of a project exceed what it is expected to receive. When a project's NPV is negative, the project is not profitable and should not be accepted for financial reasons.

Like the IRR method, there are disadvantages to the NPV method. It may be difficult to determine the required rate of return or discount rate to use to discount cash flow. Also, NPV calculations are biased towards larger projects. One project may have a higher NPV, but its rate of return may be lower, and the total cash outlay may be higher than a smaller project.

Is IRR or NPV Better for Capital Budgeting?

IRR and NPV have two different uses within capital budgeting. IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.

How Is IRR Calculated?

IRR is calculated by setting the NPV of a series of cash flows to zero and solving for the discount rate. IRR can be solved manually through trial and error, though it is more efficient to leverage software programs to calculate IRR.

How Is NPV Calculated?

NPV is calculated by finding the present value of each cash flow for each period, including any initial cash outflow that occurs immediately. The discount rate used is self-selected as the required rate of return for the project. Once all discounted cash flows have been calculated, add all cash flows to arrive at the net present value.

The Bottom Line

Both IRR and NPV can be used to determine how desirable a project will be and whether it will add value to the company. While one uses a percentage, the other is expressed as a dollar figure. While some prefer using IRR as a measure of capital budgeting, it does come with problems because it doesn't take into account changing factors such as different discount rates. However, NPV also has limitations such as being unable to compare project sizes or requiring upfront rate estimations.

What is the major disadvantage of the internal rate of return method?

What is one of the biggest disadvantages to the internal rate of return method of capital investment analysis?

What are the main disadvantages in the use of the internal rate of return IRR method in analyzing capital investment proposals?

What are the advantages and disadvantages of using internal rate of return?