3. Discussion

The IRR is a very popular profitability measure in capital budgeting. The reasons for its popularity are simple:
 

  • Requires no explicit discount rate estimation: The IRR allows managers to assess the profitability of a project without having to explicitly estimate the relevant discount rate. As we discuss elsewhere, estimating discount rates is often not straightforward. The IRR approach can therefore be less computationally intensive and less time consuming than the NPV approach. Note, however, that manager still need to have a rough understanding of the cost of capital when using the IRR rule, as they have to decide whether a specific IRR is good or bad.
     
  • Easy to communicate: Equally importantly, the IRR is very easy to communicate. Many decision makers think in returns rather than dollar value added. The IRR tells them the average annual return they can expect to earn when investing in a certain project. Especially in long-term projects and projects that involve professional money (for example venture capital or private equity), that piece of information is very valuable. Using the IRR can therefore make it easier for managers to convince investors that a project is financially attractive.

 

Given its relevance and popularity, it is therefore important that financial managers are able to calculate and interpret the IRR. As it turns out, that is oftentimes not as easy as it sounds. The following sections address some challenges that managers often face when working with the IRR.