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Start-Ups and Public Relations
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How to Reduce Return Rates in Retail?
In the previous article, we have already seen that the return policy offered by a retailer can deeply influence their profitability as well as their cash flow. Over the years, retailers have realized the tactical importance of return rates. As a result, they have taken measures to reduce the same. In this article, we will […]
Disadvantages of Bootstrapping
In the previous article, we have learned about what self-financing i.e. bootstrapping is. We have also learned about what are the various advantages of using the bootstrapping technique. However, despite the advantages listed in the previous article, relatively few startup founders actually go the bootstrapping route. This is because of the fact that bootstrapping also […]
How Salary Caps Work in Sports Leagues?
It is common knowledge that sports leagues all over the world rake in billions of dollars when it comes to annual revenue. It is also known that all these leagues have a well-developed fan base. Famous leagues such as the English Premier League, the NBA, etc have various sports franchises which are very competitive. They […]
In the past article we discussed about the concept of internal rate of return. We discussed how it could be used to make proficient investment decisions.
In this article we will see the drawbacks and pitfalls of the Internal Rate of Return (IRR) number. We will see how these problems make it a number that must be handled with care and why decisions based entirely on the IRR rule may not be good for the firm. The problems with Internal Rate of Return (IRR) are as follows:
Problem #1: Multiple Rates of Return
The Internal Rate of Return (IRR) is a complex mathematical formula. It takes inputs, solves a complex equation and gives out an answer. However, these answers are not correct all the time.
There are some cases in which the cash flow pattern is such that the calculation of IRR actually ends up giving multiple rates. So instead of having one IRR, we would then have multiple IRR’s. Sometimes the IRR number can even go in the negative indicating that the firm is actually losing value. Although, we know that this is not the case in reality.
The thumb rule is that if the cash flow patterns change signs more than ones then the firm sees more than 1 IRR. These numbers are therefore not wholly accurate. They are simply the result of a mathematical error of a complex formula. In such cases, using the NPV is a better choice.
And most projects that firms have to choose from will usually have cash flows which change signs many times. Sometimes there is a maintenance outlay required during the later life of the project.
Sometimes disposing off the waste at the end of the project requires an outlay in the end. In each of these cases, Internal Rate of Return (IRR) is not a good basis for decisions.
Problem #2: Multiple Discount Rates
Even if the cash flow does not change signs in the middle of the project, the IRR could still be very difficult to compute and implement in reality.
We must only invest if the IRR is greater than the opportunity cost of capital. But, here we are just discussing one opportunity cost of capital.
Time value of money tells us that there are in fact several opportunity costs of capital, changing each year because of the effect of increasing number of years.
So, to use the IRR rule in such a case we have two choices:
Either ways, it becomes a mathematical hassle. This is both difficult to comprehend as well as difficult to compute. It is for this reason that firms usually prefer the net present value (NPV) rule to the Internal Rate of Return (IRR) rule.
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