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Why Orders are Important in Forex Markets ? There is a need for some form of automation in the Forex markets. This is because the market runs 24 by 7. Therefore the value of investor holdings and therefore their net worth keep changing 24 by 7. Hence if an open position is not managed for […]
Home Country Bias
The activities of most investors have historically been limited to their home country. This is largely because earlier, there were rules which made the transfer of capital between countries an arduous process. Not only was the process complex, but it also took a lot of time and was riddled with transaction costs. This is the […]
Double Entry Bookkeeping System in Accounts
The double entry system of bookkeeping is said to have revolutionized growth in modern business. It is only because businesses are able to keep track of their growing scale of transactions efficiently that they grow further. This has been facilitated by a well designed, error preventing accounting system called the double entry system. Here are […]
Understanding Investor Focus on Burn Rate
Burn rate is a metric that is specific to the start-up world. On the one hand, most of the financial world is obsessed with frugality but at the same time, investors in start-up companies often pressurize the management to spend as much money as possible within a short span of time. The excess of spending […]
Issues With Sponsorship Levels
In the previous article, we have already seen what sponsorship tiers or sponsorship levels are. We have also seen the various benefits that such a sponsorship arrangement can provide to both the sponsor as well as the sponsored sports entity. Hence, we know why sponsorship levels are widely used as a financing arrangement across various […]
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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