The Value of Internal Rate of Return - Assignment Example

of Topic: The generally held view is that the IRR is a useful measure of investment worth if treated with caution, given its wide acceptance both in bond market and in industry generally. Consider the role, if any, that the IRR should have in capital budgeting. The value of Internal Rate of Return (IRR) as a useful measure of investments if treated with caution may in fact be appreciated, given that its wide acceptance in practice. This paper therefore attempts to prove the same by knowing its advantages and limitations as against other methods in order to enhance its value. As a method in evaluating capital budgeting decisions, its role can only be taken with seriousness since its wrong use could have disastrous consequences as companies makes long term commitment to their resources. What is the IRR and what makes it useful? The internal rate of return is a rate used by companies to decide whether they should make investments by comparing the same with the cost of capital or hurdle rate. Whether it is a bond investment, a stock investment or real estate, the return is measured in rates. No wonder it is a more preferred method of measuring the efficiency of an investment over that of the Net Present Value (NPV) method which uses value or magnitude in declaring whether an investment is acceptable or not. Its use with bonds on evaluating yield on investment is readily useful as a bond investment usually starts with an initial cash outflow and followed by a series of cash inflows. The same principle may be observed in the case of stocks if the there is assured yearly distribution of dividends after the initial investments on stocks. Hence the same principle may be applied with other kinds of investments where there is an initial cash outflow that will be followed by a series of cash inflows. Since various investments attractiveness are expressed in rates of return, the use of IRR would allow a more convenient and easy way to make a decision by just taking the investment which will yield a rate higher one than cost of capital or opportunity cost of an alternative investment which is also expressed in rates. Given the ease of its comparison it has therefore advantages over that of other methods like NPV. Another method that is expressed in rates from which it could be compared is the accounting rate of return (ARR) but since the latter does not consider time value of money1, IRR then occupies a higher ground as that of the NPV. But since NPV is expressed in value as state earlier, more executives are using the same. It can therefore be assumed that if all other things are equal, it is more tempting to use IRR over that of the NPV. Hence in the case of independent projects the results of the NPV and IRR are the same. This means that what NPV accepts, IRR also accepts. Similarly, what IRR rejects NPV also rejects. Hence there is no issue that in case of independent projects, the IRR could be used to the exclusion of the NPV or vice versa.2 But why choose one over the other if the result of one method could be confirmatory of the result of the other? Another advantage of IRR over NPV is the information on project’s “safety margin.” This happens when two projects have same NPVs , while a first project may have a higher IRR over a second projector vice versa. Brigham illustrated that an investment of $10,000 which is expected to produce $16,500 after one year is better than a project costing $100,000 that has an expected pay off of $115,000 after one year.3 Given its advantages over that of the NPV, it may be proper to know its limitations as against the NPV. The first one is that it should not be used in mutually exclusive projects because it is possible that the decisions arrived at may be wrong. This happens when one project has a higher initial investment than a second mutually exclusive project, while the first project may have a lower IRR but a higher NPV. In this case, the use of the NPV should be upheld because the latter could cause a higher increase in share holders’ wealth despite the lower IRR. This is of course with the assumption that there are no capital constraints. This principle may be explained by the fact that the IRR makes no assumptions about the reinvestment of the positive cash flows from a project; hence it should not be used to compare projects of different duration and with overall pattern of cash flows. But there is remedy if the rate of return as basis is preferred by the decision makers -- that it to use the Modified Internal Rate of Return (MIRR) which could have a better indication of a project’s efficiency in contributing to the firm’s discounted cash flow. The second limitation of IRR is that it should not be used in the usual manner for projects that start with an initial positive cash inflow. Sometimes a capital budgeting decision starts with a cash outflow but it could happen that a customer makes a deposit before the start of a project. This would cause single positive cash inflow. If this will be followed by a series of negative cash flows, the use of IRR would not be appropriate. . The third limitation is when a multiple sign changes in the series of cash flows4 such as a positive amount, followed by negative amount, then positive amount, then negative amount and then positive amount. What happens in this case is a multiple IRR, thus it may be improper if not impossible to use the IRR decision rule.. The fourth limitation is distortion created with the assumption that IRR measures the actual annual profitability of an investment by having intermediate cash flows to be reinvested at the project’s IRR rate. This false assumption surely overstates the actual rate of return. To remedy the same Modified Internal Rate of Return (MIRR)5 should be used so that assumed reinvestment rate would be the same as the project’s cost of capital. Given its advantages and limitations what could be the consequence of using IRR.6 The study by Kelleher and MacCormack about the preferential use of IRR is very much appropriate to discuss. The authors cited an academic research which found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects.7 Using their own research, the authors pointed out the appetite to risky behaviour by investors in an informal survey of 30 executives at corporations, hedge funds, and venture capital firms.8 The authors found that only 6 from the 30 were fully aware of IRRs most critical deficiencies. They were surprised to find the extent of the use of IRR after their reanalysis of about two dozen actual investments that one company made on the basis of attractive IRR. After their recalculation and the applications of IRR are corrected in terms of natural flaws and prioritization of company’s projects, Kelleher and MacCormack (2004) stated that decision would have changed considerably. In attributing the ease of comparison which they believed to outweigh most managers’ perspective of largely technical deficiencies, there indeed saw the resulting immaterial distortions in certain cases.9 Clearly then there is danger in disregarding the limitations of the use of the IRR. To understand the implications of the same there is need to dig further into wrong assumptions that are also being disregarded into its use. What could be the wrong assumptions in the use of IRR? Kelleher and MacCormack were aware of the trouble undergone by practitioners who often consider the internal rate of return as the annual equivalent return on a given investment when it is not the real one. The intuitive appeal brought by the ease of comparison cannot be taken as a true indication of a projects annual return on investment since this could only happen when the project generates no interim cash flows or those interim cash flows generated were really reinvested at the actual IRR10. The real rate of reinvestment is the cost of capital hence the danger of adamantly using IRR without regard of the limitations. To use IRR therefore when the cost of capital is the IRR would be causing the use of the IRR to be very limited. Another sensitive area pointed by the Kelleher and MacCormack11 is the fact that the IRR makes the assumption that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows. The authors feared about the overestimated measure of value based on the use of IRR for the interim cash flows if not corrected. In asserting rather the use of net present value by contrast, they pointed out the fact about the general assumption of a company earning its cost of capital on interim cash flows.12 It is not therefore hard to see the relationship of wrong assumptions with wrong decision and sometimes wrong decision is worse than not having a decision. After carefully discussing the advantages and limitations of the use of the IRR, it is not difficult to see technical aspect in the use of formula which should not be dismissed lightly as the implications could really be serious for capital budget decisions. Capital budgeting must be noted as one of the important decisions that must be made by managers and any decision done because of wrong assumption or wrong judgment or use of method could have very disastrous effects on the company. The decision would put the company into committing its large resources to projects which could not just be stopped or resold without incurring huge losses. It could be fatal for the company since decision on capital budgeting is matter of survival for almost all companies. Kelleher and MacCormack explained that when managers choose to finance only the projects with the highest IRRs, these managers may just be looking at the most distorted calculations and result would be to destroy the shareholder value. To make things worse it could happen that companies may be making unrealistic expectations for themselves and for shareholders, when they wrongfully believe that they have made the correct decisions when in fact they have not. This therefore has the result of potential confusion as far as communicating with investor and giving managerial which may be inflated.13 Kelleher and MacCormack had the chance to demonstrate the danger of using IRR wrongly in terms assumptions about reinvestment which can result to major capital budget distortions. They cited a hypothetical assessment of two mutually exclusive projects, which they labelled projects A and B. Both projects are assumed to have identical cash flows, the same risk levels, the same durations and identical IRR values at a given rate of 41%. They noted that an executive who will use IRR as the way of measuring the acceptability of an investment would have the feeling confidence in being indifferent on which to choose between the two projects.14 They stated that a great mistake is committed if selection is done after failing to examine the relevant reinvestment rate15 for the interim cash flows that may be generated by the project. If both have the same cost of capital for redeploying the cash inflows, there is no problem. But if Project B cash inflows could only be reinvested at lower rate of 8 percent then Project A should be accepted.16 Of course as indicated earlier the better way to resolve of which to accept is to use the NPV since the projects appear to be mutually exclusive. It can be concluded that IRR is a useful measure of investments if treated with caution considering the ease of its use by comparing the same with the rates of other alternative investments. In addition provides of safety margin information which NPV may not give. On the other hand, its disadvantages or limitations which include its inapplicability to mutually exclusive projects and the wrong the wrong reinvestment rate that is assumed. Disregarding the limitations could produce distorted analysis and therefore wrong conclusions and wrong decision. Its role in the capital budgeting cannot be overemphasized because of the ease and convenience of its use. However, given the danger in the use IRR method in case of mutually exclusive projects, the decision maker is advised not to use IRR. Instead the NPV method should be used. Works Cited: Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK Droms (1990) Finance and Accounting for Non Financial Managers, Addison-Wesley Publishing Company, England Graham Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field, ” Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Sydney, Australia Kelleher and MacCormack (2004), Internal Rate of Return: A Cautionary Tale, The McKinsey Quarterly, McKinsey & Co., October 20, 2004 Lazaridis, I. , Capital Budgeting Practices: A Survey in the Firms in Cyprus; Journal of Small Business Management, Vol. 42, 2004 Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK Van Horne (1992) Financial Management Policy, Prentice-Hall, Inc., London, UK Weston and Brigham (1993) Essential of Managerial Finance, Dryden Publishers London, UK Zivney, T. , et. al, Reexamination of the Investment Performance of Junk Bonds ; Quarterly Journal of Business and Economics, Vol. 32, 1993 Read More