Risks Faced By Banks
It is often said that profit is a reward for risk bearing. Nowhere is this truer than in the case of banking industry. Banks are literally exposed to many different types of risks. A successful banker is one that can mitigate these risks and create significant returns for the shareholders on a consistent basis. Mitigation […]
Why Doesn’t the Private Sector Invest In Infrastructure Projects?
As explained in the previous articles, the infrastructure sector is facing a significant funding gap. There is an urgent need to double the spending on infrastructure projects. One of the ways to fulfill this gap is by increasing the participation of the private sector in infrastructure projects. At the present moment, the private sector is […]
Revenue Sharing in Sports Leagues
The economics of sports leagues is quite complicated. This is because of various factors. However, two of the most important factors are: The revenue is generated at the central level i.e., by the franchisor, and at the franchise level as well i.e. local revenue. For instance, broadcasting rights are monetized at the central level. However, […]
Pension Fund Governance Structure and its Need
Since pension funds manage assets worth billions or even trillions of dollars. This means that it is crucial to create a structure that manages the pension fund itself. Since the pension fund industry is highly regulated, it is important for the fund to have a structure in place which allows for quick and effective decision-making. […]
What is Acqui-Hire?
Acqui-hire is a different type of acquisition strategy which has come into existence with the emergence of technology-based start-ups. For many start-up companies, employees are now their biggest assets. Hence, it should not be surprising that other companies may want to acquire this employee base to meet their own business needs. Hence, if a tech […]
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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