Let’s say you google the term “Internal Rate of Return” and then you’ll see a complex formula and even hard-to-understand explanation. But we don’t do that here. You see, it is just a method to know how profitable a project or an investment can be in the future. That’s the explanation of the Internal Rate of Return in the simplest words possible. And don’t get confused though, it is often referred to as “break-even” interest rate, just so you know. But that’s not why we are here, you know, just to give you tiny explanations, we are here to talk about the Internal Rate Of Return advantages and disadvantages by going a bit in-depth. So, here we go.

Advantages of Internal Rate of Return (IRR)

1. It Accounts for the Time Value of Money and That’s Huge!

The idea that money today is worth more than the same amount of money in the future is a very significant component of the internal rate of return (IRR) approach is a time value of money (TVM) estimator, and if you get down to think about it for a second, it really is quite fascinating. In other words, IRR brings the amount of future money back to today. All in all, this helps to show how grossly the project profit has been over the years.

2. IRR is Super Simple, Even If You’re Not a Finance Guru

You see, IRR is fairly straightforward and uncomplicated to apply and understand, even if you do not have a strong financial background like some others do, you know? Once you find out your IRR, it is easy to read: If the IRR is more than that of the project or other investments that have been undertaken in the past, that means that the project is a winning one. Simple as that!

3. No Guesswork with a “Hurdle Rate”

The IRR method leaves no ambiguity like the “hurdle rate” ones. Like, other financial methods are based on your attempt to set a “hurdle rate” (which is the minimum acceptable return rate for a project), but not IRR. With this one, the method of analyzing the project is also very simple because it does not require you to estimate anything else but the return rate itself.

4. Easy Peasy Comparisons Between Projects

You see, the way that you can directly compare all of your ventures aka projects by External Rate of Return, see how the present worth of your projects can be directly compared. With IRR of course expressed as a percentage, it is easier to determine which project will be the best investment, you know? For instance, if you compare 15% of IRR and 10% of IRR in two projects, it will be very easy for you to decide that the first project will likely be a better choice, don’t you think?

5. Percentages Make Profitability Clear as Day

Not just that though, another point in favor of IRR is that it is articulated via a percentage that other people can relate to because it will be less technical a language than what you have been saying. It’s more logical and transparent to understand how much revenue one will earn when the income is expressed in rates. With this kind of methodology, a percentage also serves as a basis for comparing projects, irrespective of their scale, you know, giving a more lucid insight into the overall profitability of such projects.

Disadvantages of Internal Rate of Return (IRR)

1. It Doesn’t Consider the Size of the Project

Sure, we must say that one of the biggest faults of the IRR is not taking into consideration the project size while making decisions, you know? Don’t get what we are saying? Well, for instance, a little project with a high IRR might seem more appealing than a bigger one, which has a lower IRR, even if the larger project may bring in more money overall. The IRR only looks at the percentage return and not the actual dollar figure, which may be misleading when it comes to differentiating between different-sized projects. Therefore, you could end up selecting the initiative with a more significant return and, meanwhile, lose out on greater total profitability from another one.

2. Unrealistic Reinvestment Assumptions, It’s Not Always That Simple

Not just that though, one major drawback of the IRR method is that it assumes that all future cash flows from the project will be reinvested at the same rate as the IRR itself, which in itself is unrealistic because it is often improbable that one will find investment opportunities offering the same return rate. For instance, if your project is showing a high IRR of 20%, the method bottlenecks the idea that you can reinvest future profits at 20%, which is nearly impossible in most instances.

3. The Annoying “Multiple IRR” Problem

Did you know that the IRR calculation can sometimes generate more than one rate of return if the project has irregular or unpredictable cash flows? All in all, in such cases, it is likely that reliance on IRR alone may not get you the right answer, and you will need to use other approaches such as Net Present Value (NPV) for assistance in making a more transparent decision.

4. Not So Great for Picking Between “Mutually Exclusive” Projects

See, just to put it simply, if you are in a situation where you have two projects to select from, the IRR method will not necessarily solve the problem for you. And why’s that though? Well, you see, the reason for that is that the IRR method just concentrates on the percent yield of the investment, but it does not consider how much revenue in total each project will generate, get it now? Like, a project with a bigger IRR may at first sight appear to be better than the one with a smaller IRR, but it could conceivably happen that the one with the lower IRR is most profitable in total.

Conclusion

That’s pretty much it for today. Now we truly hope that you thoroughly understand why this IRR thing is, what its use is, and how it can be beneficial in different ways. But as we talked about, can’t just simply rely on the internal rate of return, there are other things you should consider before making any solid decision.