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 It will give the correct decision advice assuming a perfect capital market. It will also give correct ranking for mutually exclusive projects. NPV gives an absolute value. DIS ADVANTAGE NPV It is very difficult to identify the correct discount rate.

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

. With the NPV method. percentage. the advantage is that it shows the return on the original money invested. The 'multiple IRR problem' can also be an issue. the advantage is that it is a direct measure of the dollar contribution to the stockholders.increase the firm's value. it can give you conflicting answers when compared to NPV for mutually exclusive projects. 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. at times. the disadvantage is that the project size is not measured 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 disadvantage is that. Considers all the cash flows Considers the time value of money Considers the risk of future cash flows (through the cost of capital) With the NPV method.

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