Advantages and Disadvantages of Internal Rate of Return Method

Advantages of Internal Rate of Return Method

IRR Method - Advantages, Disadvantages

IRR Method – Advantages, Disadvantages

A brief explanation of advantages of Internal Rate of Return method is presented below.

1. It considers the time value of money even though the annual cash inflow is even and uneven.

2. The profitability of the project is considered over the entire economic life of the project. In this way, a true profitability of the project is evaluated.

3. There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal Rate of Return method is better than Net Present Value method.

4. Sometimes, the pre-determination of cost of capital is very difficult. At that time, Internal Rate of Return can be used to evaluate the project.

5, The ranking of project proposals is very easy under Internal Rate of Return since it indicates percentage return.

6. It provides for maximizing profitability.

7. Internal Rate of Return takes into account the total cash inflow and outflows.

8. It gives much importance to the objective of maximizing shareholder’s wealth.

Disadvantages of Internal Rate of Return Method

The disadvantages of Internal Rate of Return are listed below.

1. This method assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project. If the average rate of return earned by the firm is not close to the internal rate of return, the profitability of the project is not justifiable.

2. It involves tedious calculations.

3. This method gives importance only to the profitability but not consider the earliest recouping of capital expenditure. The reason is that sometimes Internal Rate of Return method favors a project which comparatively requires a longer period for recouping the capital expenditure. Under the conditions of future is uncertainty, sometimes the full capital expenditure can not be recouped if Internal Rate of Return followed.

4. The results of Net Present Value method and Internal Rate of Return method may differ when the projects under evaluation differ in their size, life and timings of cash inflows.

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