Advantages and Disadvantages of IRR

Internal Rate of Return (IRR) is the discount rate that makes the net present value of all cash flows from an investment project equal to zero.

Advantages of Internal Rate of Return:

1) This technique gives equal importance to all the cash flows. We just need to identify the point at which the present value of cash inflow is equal to present value of cash outflow.

2) It is a good method of capital budgeting. The IRR method is considered more popular and straightforward than the NPV approach.

3) IRR can be used to rank different prospective projects and the project with the highest IRR would be considered the best.

4) This method considers the time value of money and is therefore more realistic than the Accounting Rate of Return (ARR) method.

The Disadvantages of Internal Rate of Return:

1) This technique can be difficult to understand.

2) IRR does not take into account of the cost of capital, thus it should not be used to compare projects of different duration.

3) The IRR could be difficult to find if we want to calculate it by using trial and improvement.

4) It fails to recognize the varying size of different investment projects.

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