Answers:
The Internal Rate of Return (IRR)
method is another discounted cash flow technique, which takes account of the
magnitude and timing of cash flows. Other terms used to describe the IRR method
are yield on an investment, marginal efficiency of capital, rate
of return over cost,
time-adjusted
rate of internal return and
so on. The concept of internal rate of return is quite simple to understand in the
case of a one-period project. Assume that you deposit `10,000 with a bank and would get
back `10,800 after one year. The true rate
of return on your investment would be:
Rate of return
= 10,800-10,000 / 10000
= 0.08 or 8%
The amount that you would obtain
in the future (`10,800)
would consist of your investment (`10,000)
plus return on your investment (0.08 × `10,000):
10,000 = 10800/1.08
You may observe that the rate of
return of your investment (8 per cent) makes the discounted (present) value of
your cash inflow (`10,800)
equal to your investment (`10,000).
Acceptance
rule
_ Accept if IRR > k
_ Reject if IRR < k
_ Project may be accepted if IRR = k
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Merits
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Demerits
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Considers
all cash flows
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Requires
estimates of cash flows which is a tedious task
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True
measure of profitability
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Does
not hold the value additivity principle (i.e., IR`of two or more
projects do not add)
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Based
on the concept of the time value of money
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At
times fails to indicate correct choice between mutually exclusive projects
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Generally,
consistent with wealth maximization principle
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At
times yields multiple rates
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Relatively
difficult to compute
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