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Internal Rate of Return: Advantages & Disadvantages

Internal Rate of Return: Advantages & Disadvantages
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  • 0:00 Internal Rate of Return
  • 0:54 Advantages of the IRR
  • 1:30 Disadvantages of the IRR
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Lesson Transcript
Instructor: Noel Ransom

Noel has taught college Accounting and a host of other related topics and has a dual Master's Degree in Accounting/Finance. She is currently working on her Doctoral Degree.

This lesson defines and explains the use of the internal rate of return. The lesson also explains the advantages and disadvantages of the internal rate of return.

Internal Rate of Return

The internal rate of return (IRR) is used to measure and compare the profitability of various business projects and investments. The IRR is a common measurement used by business leaders to decide which projects will yield the greatest results in the form of return on investments.

Let's say a company has three separate projects to evaluate, and the business leaders of the company don't know which project will yield the highest profit. Each project has the same cost of capital (financing costs), so the higher the IRR for the project, the more profitable the project will be, assuming all other risks and factors are equal. Business leaders will only accept a project if the IRR is above the cost of capital for the project, and they'll reject the project if the IRR is below the cost of capital.

Advantages of the IRR

One of the advantages of using the internal rate of return is that the method provides the exact rate of return for each project as compared to the cost of the investment. The internal rate of return thus allows the investor to get a sneak peek into the potential returns of the project before it begins. The IRR also considers the time value of money, which is a measure of the future earning potential of money. This makes the process of evaluating returns more accurate and credible. Finally, the concept of IRR is easy to understand and the calculations are simple.

Disadvantages of the IRR

The disadvantage of the internal rate of return is that the method does not consider important factors like project duration, future costs, or the size of a project. The IRR simply compares the project's cash flow to the project's existing costs, excluding these factors. Thus, it would not be wise for business leaders to use the IRR to compare projects with different durations or sizes.

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