Exchange Rate Regimes
International trade is a vital component of the economy of any nation. Also, international trade is highly dependent upon exchange rates. It is for this reason that the choice of the type of exchange rate regimes is very important. To a layman, all exchange rate regimes might appear to be similar. However, the reality is […]
Three Layers of Banking as a Service
The concept of banking as a service is revolutionary. This is because banking as a service is a mechanism using which commercial banks can now collaborate with other non-banking entities in order to expand the coverage of their services. Hence, this model has led to a decomposition of the commercial banking value chain. Earlier, all […]
Want to Become a Financial Professional? Read on for Some Tips on How You Prepare
Are you aspiring for a career in banking and finance and financial services? Do you dream of working in a glitzy office and be part of a glamorous club of professionals that travels around the world and wines and dines in style? Read for on for some tips and suggestions on how you can prepare […]
Choosing a Valuation Model
Now, since we are aware that there are actually multiple models that can be used to value any given company or asset, the next question that arises is which one should we use? How do we know whether a given valuation model is more appropriate for a given company than the others? The answer is […]
Components of a Financial Plan
Financial planning is often confused with investment planning. Although investment planning is a major part of financial planning, it does not encompass the entire concept. There are several more components to financial planning as well. In this article, we will have a closer look at the various components of a financial plan. Budgeting: A lot […]
In the past article we discussed about the concept of internal rate of return. We discussed how it could be used to make proficient investment decisions.
In this article we will see the drawbacks and pitfalls of the Internal Rate of Return (IRR) number. We will see how these problems make it a number that must be handled with care and why decisions based entirely on the IRR rule may not be good for the firm. The problems with Internal Rate of Return (IRR) are as follows:
Problem #1: Multiple Rates of Return
The Internal Rate of Return (IRR) is a complex mathematical formula. It takes inputs, solves a complex equation and gives out an answer. However, these answers are not correct all the time.
There are some cases in which the cash flow pattern is such that the calculation of IRR actually ends up giving multiple rates. So instead of having one IRR, we would then have multiple IRR’s. Sometimes the IRR number can even go in the negative indicating that the firm is actually losing value. Although, we know that this is not the case in reality.
The thumb rule is that if the cash flow patterns change signs more than ones then the firm sees more than 1 IRR. These numbers are therefore not wholly accurate. They are simply the result of a mathematical error of a complex formula. In such cases, using the NPV is a better choice.
And most projects that firms have to choose from will usually have cash flows which change signs many times. Sometimes there is a maintenance outlay required during the later life of the project.
Sometimes disposing off the waste at the end of the project requires an outlay in the end. In each of these cases, Internal Rate of Return (IRR) is not a good basis for decisions.
Problem #2: Multiple Discount Rates
Even if the cash flow does not change signs in the middle of the project, the IRR could still be very difficult to compute and implement in reality.
We must only invest if the IRR is greater than the opportunity cost of capital. But, here we are just discussing one opportunity cost of capital.
Time value of money tells us that there are in fact several opportunity costs of capital, changing each year because of the effect of increasing number of years.
So, to use the IRR rule in such a case we have two choices:
Either ways, it becomes a mathematical hassle. This is both difficult to comprehend as well as difficult to compute. It is for this reason that firms usually prefer the net present value (NPV) rule to the Internal Rate of Return (IRR) rule.
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