The biggest potential fault for using internal rate of return (IRR) as the only measure of the economic feasibility of a project is that it uses a single discount rate to measure all investments. Other potential problems are that it may be inadequate for projects with varying positive and negative cash flows or longer-term projects for which financial analysts expect the discount rates to vary.
When a company begins a new project or expansion, it finances the expenses through debt, equity or both. The financing of the project is referred to as its cost of capital. Financial analysts calculate each project's IRR to determine the expected profitability of the project as compared to its costs. The IRR discounts future cash flows of a project to their net present value (NPV). The discount rate is the rate of return at which the NPV of future cash flows equals zero. If the project has an IRR that is higher than its cost of capital, the company will consider it economically feasible.
One Discount Rate
Financial analysts often use the weighted average cost of capital (WACC) as the discount rate when performing IRR calculations. WACC is a representation of the cost of both debt and equity financing and is the minimum interest rate a project must return for analysts to consider it profitable. WACC calculations have multiple inputs, such as the amount of debt and equity financing used for a project. Using only one discount rate when performing IRR calculations may result in an inaccurate measure of an individual project's economic feasibility because the WACC inputs may not the same for all projects.
Expected Discount Rate Changes
Some analysts use the capital asset pricing model (CAPM) instead of the WACC as the discount rate for IRR calculations. One of the inputs for the discount rate using the CAPM is the risk-free rate of return. Since no investments are truly risk free, financial analysts use the rate of return on a government security such as a Treasury bill. Over the short-run, this input is unlikely to change significantly and the IRR may be an adequate measure of the expected rate of return and economic feasibility of a project. Over the long run, the rates of return on government securities such as T-bills are likely to change. As a result, IRR calculations for long-term projects may be an inaccurate measure of economic feasibility and/or profitability.
Cash Flow Issues
Financial analysts cannot calculate the IRR if the cash flows of a project are either all positive or all negative. The typical cash flows for a project begin with a negative number due to the initial cash outlay, while future cash flows are positive. In this case, IRR may be an adequate measure for profitability and feasibility. If a series of cash flows has more than one reversal, meaning cash flows change from positive to negative more than one time over the life of a project, there are multiple IRR solutions. Using just one IRR for such a project is not an adequate measure of profitability or feasibility.
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