What Are the Potential Faults in Using the IRR as a Capital Budgeting Technique?

Buying a van for your business is a capital budgeting decision.

Buying a van for your business is a capital budgeting decision.

Deciding to purchase an additional van for your flower delivery business is a capital budgeting decision. Capital budgeting is concerned with investing in real assets (projects) and capital budgeting techniques help determine whether or not the investment will be profitable. It involves comparing the cost of the investment and the cash flows that the investment is expected to generate over time. The internal rate of return rule is an intuitive approach to making capital budgeting decisions, but the IRR has some problems under certain circumstances.

NPV and IRR

The net present value rule is closely related to the IRR. The NPV is calculated by summing all discounted cash flows associated with project. The IRR is the rate that results in a zero NPV. Both methods rely on the company’s cost of capital and estimated incremental cash flows. If your flower delivery business obtains loans from the local bank at a rate of 9 percent, that is your cost of capital. Incremental cash flow estimates are obtained by forecasting the increased revenues and subtracting the associated expenses -- or in some cases the cost savings -- associated with the project.

Applying the Decision Rules

Suppose the van cost $15,000 and you expect the purchase to increase your incremental cash flows by $3,000 each year for the next seven years. The NPV is calculated as follows: -$15,000 + $3,000/(1+.09) + $3,000(1+.09)^2 + $3,000(1+.09)^3 + … +$3,000(1+.09)^7 = -$15,000 + 2,752.29 + 2,525.04 + 2,316.55 + 2,125.28 + 1,949.79+1,788.80+1,641.10 = $98.86. The decision rule is to accept all projects when NPV is greater than zero. A positive NPV of $98.86 indicates that purchasing the van is a good idea. Calculators and spreadsheet functions can help determine that if the cash flows were discounted by 9.20 percent instead of the 9 percent cost of capital, the NPV would be zero. Therefore, the IRR is 9.2 percent. The decision rule is to accept the project if the IRR is greater than the cost of capital, again indicating that the purchase is a good idea.

Multiple IRRs and Nonstandard Projects

When cash flows associated with a project change signs once, it is called a standard project. The van project has standard cash flows because they change signs only once: The first investment is a negative cash flow and all other cash flows are positive. Sometimes projects require multiple investments or may otherwise be associated with more than one change in cash flow signs. These are nonstandard projects. One of the problems with the IRR is that there may be several values that produce a zero NPV for nonstandard projects, and it may be hard to understand which if any of the multiple IRRs is valid.

The IRR and Multiple Projects

Consider two additional potential projects for your flower business. One involves selling print copies of flowers over the Internet, with an IRR of 8.5 percent. The other is the purchase of an SUV for delivering flowers, with an IRR of 10 percent. The 8.5 percent IRR project is an independent project that does not impact the other two projects, so you would accept it only if the IRR were greater than 9 percent cost of capital. The 10 percent SUV and 9.2 percent van investments are mutually exclusive projects because you plan to choose only one. However, the IRR is not a reliable method of ranking mutually exclusive projects. You cannot conclude that the SUV is a better choice than the van. You need to choose the project with the higher NPV.

About the Author

Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.

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