The projects that an organization initiates should result in some benefit for it, which in most cases is a profit from the investment. Internal rate of return (IRR) is an approach often applied by project managers to evaluate the outcome and income expected from investing in a new project. IRR calculations consider the revenue and expenses of a project at their present value. Additionally, IRR shows a discount rate, which is a metric used to evaluate “the present value of future cash flows.”
Notably, this is a simple and straightforward way to calculate the return generated by a project. One difficulty is the need to use additional materials, such as tables to determine the present value. Moreover, pocket calculators can help calculate IRR without the need to refer to the tables, making the process even easier. When IRR is higher than the hurdle rate in comparison to the company, or the minimum it expects to earn from a project, it is worth considering this investment opportunity.
The first advantage is, as mentioned, it is easy to use and provides accurate estimations for the returns generated by a project. The additional advantage is that one can compare multiple projects and evaluate their return on investment (ROI) rates to determine a project that will generate a better or faster return. Hence, the metric is very useful when working in a multi-project environment because it allows one to create a comparable assessment and evaluate the costs needed as opposed to the earnings from a project.
One disadvantage is that IRR reflects the actual rate of return if a company is able to reinvest the money gained from it in other projects with a similar IRR. Therefore, if the money is reinvested in projects with lower return rates, the organisation will be unable to receive the calculated IRR. When calculating for two projects that are not mutually exclusive, it is better to use net present value (NPV) because NVP considers the potential reinvestment opportunity and IRR does not. Finally, IRR calculations can provide several results in cases when net outflows are followed by cash flow inflows. These results are not options since only one out of the multiple results from IRR calculations is correct.