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Capital Budgeting Evaluation Techniques^123

The actual calculation of the rate is a hit-and-miss exercise because the rate is unknown

at the outset, but tables of present values are available to aid the analyst. These tables

show the present value of future sums at various rates of discount and are prepared for

both single sums and recurring annual payments.

What Does IRR Mean?

There are two possible economic interpretations of internal rate of return: (i) Internal

rate of return represents the rate of return on the unrecovered investment balance in

the project. (ii) Internal rate of return is the rate of return earned on the initial investment

made in the project.

Evaluation

A popular discounted cash flow method, the internal rate of return criteria has several

virtues :

l It takes into account the time value of money.

l It considers the cash flow stream in its entirety.

l It makes sense to businessmen who want to think in terms of rate of return

and find an absolute quantity, like net present value, somewhat difficult to work

with.

The internal rate of return criteria, however, has its own limitations.

l It may not be uniquely defined. If the cash flow stream of a project has more than

one change in sign, there is a possibility that there are multiple rates of return.

l The internal rate of return figure cannot distinguish between lending and borrowing

and hence a high internal rate of return need not necessarily be a desirable feature.

The internal rate of return criterion can be misleading when choosing between mutually

exclusive projects that have substantially different outlays. Consider projects P and Q

.

Cash Flows Internal rate Net present value

-------------- of return (%) (assuming k = 12%)

Period 0 1

P - 10,000 + 20,000 100 7,857

Q - 50,000 + 75,000 50 16,964

Both the projects are good, but Q, with its higher net present value, contributes more to

the wealth of the stockholders. Yet from an internal rate of return point of view P looks

better than Q. Hence, the internal rate of return criterion seems unsuitable for ranking

projects of different scale.