The Co-Working Business Model – How Co-Working Spaces Make Money
The sharing economy has been one of the major themes when it comes to start-up investing in the past decade. Investors and entrepreneurs have woken up to the idea that resources can be utilized in a much more optimal manner if they are shared between various people. The mega-success of the co-working business model is […]
Investment Banks and Underwriting
The primary function of investment banks is to help their clients raise equity capital. This is often done by initial public offerings. This is where investment banks provide their biggest service i.e., underwriting. Most people have a basic understanding of underwriting. They know that when an investment bank underwrites a share issue, they guarantee to […]
What is Jock Tax and How is it Calculated?
In the previous articles, we have already seen that the owners of sporting franchises are able to evade taxes even though they earn billions of dollars from the sporting league. However, this is not the case when it comes to athletes. Since athletes make large sums of money which are known to the media and […]
Cash Flow Types in Fixed Income Securities
The first thing that any investor related to fixed income markets first notices about the market is the sheer variety of the instruments being traded. A large variety also means that the trading in bonds becomes more complex. Investors need to understand the different types of fixed-income securities that are available in the market. Fixed […]
History of Accounting
One can never really understand a subject, unless they know where it came from. Therefore, a short history of the subject of accounting may be of interest to students of accounting. Here is a very brief history of how accounting evolved: Single Entry Accounting System Accounting is as old as financial transactions themselves. As soon […]
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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