One of the fundamental knowledges in financial management (ACCA FM, was ACCA F9) is Net Present Value (i.e. NPV) and Internal Rate of Return (IRR) in investment appraisal.
They are the tools for evaluating projects return so manager can decide whether to accept the projects or not, from the financial point of view.
In this short article, we focus on understanding these two financial concepts based on what ACCA FM requires.
To perform investment appraisal (or capital budgeting in some textbook), net present value (NPV) and internal rate of return (IRR) are both important and widely accepted as a measure.
A study showed about 75% of CFOs usually use IRR when evaluating investment projects. The reason behind is that IRR is easy to interpret, even laymen could easily understand why the project is accepted or rejected. 1 of examples is government infrastructure projects are presented on how good of the IRR to show the projects are beneficial to society.
What is IRR?
IRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. In other words, it is the breakeven point of accepting a financial sound project. In general, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering.
But as a professional accountant or finance profession, you should find out what the disadvantages of IRR and advise your senior if needed.
Reinvestment problem of IRR
The first problem of IRR is it assumes all future cash flows generated from projects will be reinvested at the same rate. This assumption about reinvestment can lead to major distortions in the rate of return. It is hard to believe all future cash flows can enjoy the same return by reinvesting. NPV, by contrast, using cost of capital to discount future cash flow avoids the distortions on this reinvestment risk.
Multi rate problem
Another problem of IRR against NPV is the pattern of future cash flow in the project. If the cash flow is conventional, i.e. being negative in first year and positive after, IRR should give a single solution. However, when the project cash flow is non-conventional, i.e. after initial cash outflow, a huge cash outflow is forecasted in the interim period, it is possible to have more than one IRR.
Conclusion
Even with disadvantages, IRR is still preferred by a lot of practitioners for its easy to use, especially NPR is quite complicated to handle if more than 1 discount rate applied.
Note: John R. Graham and Campbell R. Harvey, "The theory and practice of corporate finance: Evidence from the field," Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.
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