Budgeting Basics and Beyond

20.7. Internal Rate of Return (Time-Adjusted Rate of Return)

The internal rate of return (IRR) is the return earned on a given proposal. It is the discount rate equating the net present value of cash inflows to the net present value of cash outflows to zero. The internal rate of return assumes cash inflows are reinvested at the internal rate.

This method involves trial -and-error computations. However, the use of a computer or programmable calculator simplifies the internal rate -of-return process.

The internal rate of return can be compared with the required rate of return (cutoff or hurdle rate).

Rule of thumb: If the internal rate of return equals or exceeds the required rate, the project is accepted. The required rate of return is typically a company 's cost of capital, sometimes adjusted for risk.

Advantages of IRR

• Considers the time value of money

• More realistic and accurate than the accounting rate of return method

Disadvantages of IRR

• Difficult and time consuming to compute, particularly when there are uneven cash flows

• Does not consider the varying size of investment in competing projects and their respective dollar profitabilities

• When there are multiple reversals in the cash flow stream, the project could yield more than one IRR.

To solve for internal rate of return where unequal cash inflows exist, use the trial-and-error method while working through the present value tables.

Five Guidelines

1. Compute net present value at the cost of capital, denoted here as r₁.

2. See if net ...