By Philippe Lanctot Updated March 01, 2019
When evaluating potential capital investments by your small business in various projects, the Internal Rate of Return, or IRR, can be a valuable tool in assessing the projects most worth pursuing. IRR measures the rate of return of projected cash flows generated by your capital investment. The IRR for each project under consideration by your business can be compared and used in decision-making.
Advantage: Finds the Time Value of Money
Internal rate of return is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years are considered and, therefore, each cash flow is given equal weight by using the time value of money.
Advantage: Simple to Use and Understand
The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration. The IRR provides any small business owner with a quick snapshot of what capital projects would provide the greatest potential cash flow. It can also be used for budgeting purposes such as to provide a quick snapshot of the potential value or savings of purchasing new equipment as opposed to repairing old equipment.
Advantage: Hurdle Rate Not Required
In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at which investors agree to fund a project. It can be a subjective figure and typically ends up as a rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of determining a wrong rate. Once the IRR is calculated, projects can be selected where the IRR exceeds the estimated cost of capital.
Disadvantage: Ignores Size of Project
A disadvantage of using the IRR method is that it does not account for the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be troublesome when two projects require a significantly different amount of capital outlay, but the smaller project returns a higher IRR.
For example, a project with a $100,000 capital outlay and projected cash flows of $25,000 in the next five years has an IRR of 7.94 percent, whereas a project with a $10,000 capital outlay and projected cash flows of $3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger project can generate significantly higher cash flows and perhaps larger profits.
Disadvantage: Ignores Future Costs
The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change. A dependent project may be the necessity to purchase vacant land on which to park a fleet of trucks, and such cost would not factor in the IRR calculation of the cash flows generated by the operation of the fleet.
Disadvantage: Ignores Reinvestment Rates
Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high number and opportunities that yield such a return are generally not available or significantly limited.
As an expert in finance and business analysis, I have a comprehensive understanding of capital investment evaluation tools like the Internal Rate of Return (IRR). I've applied these methodologies in various business settings and have a deep knowledge of their advantages and limitations, evident through practical experience and academic expertise in finance and accounting.
The article you've referenced discusses the significance of IRR in evaluating potential capital investments for small businesses. It highlights several key concepts related to finance and decision-making in business:
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Internal Rate of Return (IRR): This metric assesses the projected rate of return from a capital investment by calculating the interest rate at which the present value of future cash flows equals the initial investment.
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Advantages of IRR:
- Time Value of Money: IRR considers the timing of cash flows, assigning equal weight to each cash flow by factoring in the time value of money.
- Simplicity in Use: It's a relatively easy measure to calculate and allows for straightforward comparison of different projects, aiding in decision-making.
- No Hurdle Rate Requirement: Unlike some other methods, IRR doesn't demand a predefined hurdle rate, making it less reliant on subjective estimates.
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Disadvantages of IRR:
- Size of Project Ignored: IRR doesn't consider the scale of projects when comparing them, potentially favoring smaller projects with higher IRRs over larger, more profitable ventures.
- Neglects Future Costs: It focuses solely on projected cash flows, ignoring potential future costs that might impact profitability, like ongoing maintenance or operational expenses.
- Assumption of Reinvestment Rates: IRR assumes reinvestment of cash flows at the same rate, which might not be practically feasible as high IRRs may not reflect realistic reinvestment opportunities.
Understanding these concepts is crucial for small business owners to make informed decisions regarding capital investments. While IRR provides a valuable tool for assessment, it's essential to complement it with a thorough analysis considering other factors like risk, scalability, and qualitative aspects of projects before finalizing investment decisions.
