>> May 5, 2010
Internal rate of return is that method of capital budgeting in which we can calculate IRR and compare it with cut off rate for selecting any project. It has following advantages and disadvantages. First we will discuss the advantages of Internal rate of return (IRR)
Advantages of Internal Rate of Return
1. Perfect Use of Time Value of Money Theory
Time value of money means interest and it should high because we are sacrifice of money for specific time. IRR is nothing but shows high interest rate which we expect from our investment. So, we can say, IRR is the perfect use of time value of money theory.
2. All Cash Flows are Equally Important
It is good method of capital budgeting in which we give equal importance to all the cash flows not earlier or later. We just create its relation with different rate and want to know where is present value of cash inflow is equal to present value of cash outflow.
3. Uniform Ranking
There is no base for selecting any particular rate in internal rate of return.
4. Maximum profitability of Shareholder
If there is only project which we have to select, if we check its IRR and it is higher than its cut off rate, then it will give maximum profitability to shareholder
5. Not Need to Calculate Cost of Capital
In this method, we need not to calculate cost of capital because without calculating cost of capital, we can check the profitability capability of any project.
Disadvantages of Internal Rate of Return
1. To understand IRR is difficult
It is difficult to understand it because many student can not understand why are calculating different rate in it and it becomes more difficult when real value of IRR will be two experimental rate because of not equalize present value of cash inflow with present value of cash outflow.
2. Unrealistic Assumption
For calculating IRR we create one assumption. We think that if we invest out money on this IRR, after receiving profit, we can easily reinvest our investments profit on same IRR. We seem to be unrealistic assumption.
3. Not Helpful for comparing two mutually exclusive investment
IRR is not good for comparing two project
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