Internal Rate of Return

1000 Words4 Pages
Internal Rate of Return Meaning of Capital Budgeting  Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.  Capital budgeting addresses the issue of strategic long-term investment decisions.  Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. Why Capital Budgeting is so Important?  Involve massive investment of resources  Are not easily reversible  Have long-term implications for the firm  Involve uncertainty and risk for the firm Capital Budget Techniques Net PresentValue Discounted BenefitCost/Profitability…show more content…
In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders’ wealth) and should thus be accepted over the second project. A method called marginal IRR can be used to adapt the IRR methodology to this case.  Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs.  Under IRR it is assumed that all the intermediate cash flows are reinvested at the IRR which always not hold true. Which approach is better  Both NPV and IRR methods yield better decision-making data based off them being sophisticated capital budgeting techniques and consider time value of money and life time of the project.  NPV and IRR methods yield better decision-making data based off them being sophisticated capital budgeting techniques as NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm’s cost of capital. 
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