Capital Budgeting with Internal Rate of Return (IRR)

Capital budgeting with internal rate of return (IRR) is one of the most common approaches taken by a company that is considering a project. This is the approach you should use if you want to see the percent return offered by a given project.

Basics

In the basic equation:

Net Present Value (NPV) = cash flow / (1 + IRR)^ time period – NPV

The relationship is solved for IRR and the rate of return is implicit to the project. This is then compared to the cost of capital of the company. If the IRR exceeds the company’s cost of capital, you should invest in the project. If IRR is lower than the cost of capital, the project should be rejected.

Drawbacks

The biggest drawback of using IRR in capital budgeting decisions is that you should not use it to compare multiple projects. Unlike, NPV, which gives you an absolute value number, IRR gives you a percentage. Project A may have a higher IRR than project B, for example, but a lower NPV. This means that while project A is more profitable internally, project B creates more wealth for shareholders. Creating share holder wealth is the goal of management so you need to be aware of these differences when comparing projects.

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