Discuss why most managers favor the internal rate of return (IRR) over other capital budgeting approaches.

Week 4 Discussion 2: Discuss Iinternal rate of return (IRR)-Sample Solution

Internal Rate of Return

Internal Rate of Return (IRR) is a type of capital budgeting that refers to the discount rate or firm cost of capital whose evaluation equates to the firm’s cash inflow value equivalent to its initial investment (Magni, 2020). It is a method companies use to express the worth of a specific project as a percentage instead of providing an absolute figure. For various reasons, managers prefer the IRR over other capital budgeting approaches like Net Profit Value (NPV). For instance, IRR is easy to use and interpret. It consists of a simple calculation that compares the value of several projects under consideration (Magni, 2020). Any business owner may quickly understand and interpret the results from an IRR when determining the type of capital investment that can potentially provide the most cash flow. Additionally, the IRR does not consider the Hurdle Rate, which helps businesses avoid the possibility of achieving an incorrect rate (Magni, 2020). The hurdle rate refers to rate of return that forms the standard for investors’ consent to fund a project. (Internal Rate of Return Essay-Example)

Also, Magni (2020) observes that it gives managers a general idea of the rate of return their companies require. It aids them in estimating the needed return rate; however, the IRR calculation does not entirely depend on this figure. They can contrast the IRR values with the hurdle rates once they reach it. The manager can reasonably choose either option if the IRR is significantly lower than the predicted rate of return. Lastly, Magni (2020) explains that the IRR helps managers consider the time value of money during project assessment. It incorporates appropriate timelines for future cashflows and gives each cash flow equal weight by employing the time value of money. (Internal Rate of Return Essay-Example)

Reference

Magni, C. A. (2020). Investment Decisions and the Logic of Valuation: Linking Finance, Accounting, and Engineering. (pp. 487-551). Cham: Springer International Publishing, ISBN: 9783030267759