Q. Illustrate the method of appraising capital investments?
One of the potency of internal rate of return (IRR) as a method of appraising capital investments is that it is a discounted cash flow (DCF) method and so takes account of the time value of money. It as well considers cash flows over the whole of the project life and is sensitive to both the amount and the timing of cash flows. It is preferred by a few as it offers a relative measure of the value of a proposed investment that is the method calculates a percentage that can be compared with the company's cost of capital and with economic variables such as inflation rates and interest rates.
IRR has numerous weaknesses as a method of appraising capital investments. Ever since it is a relative measurement of investment worth it does not measure the absolute increase in company value (and therefore shareholder wealth) which can be found using the net present value (NPV) method. A further problem occurs when evaluating non-conventional projects (where cash flows change from positive to negative during the life of the project). IRR may propose as many IRR values as there are changes in the value of cash flows giving rise to evaluation difficulties. There is a potential disagreement between IRR and NPV in the evaluation of mutually exclusive projects where the two methods can offer conflicting advice as which of two projects is preferable. Where there is disagreement NPV always offers the correct investment advice: IRR doesn't although the advice offered can be amended by considering the IRR of the incremental project. There are consequently a number of reasons why IRR can be seen as an inferior investment appraisal method compared to its DCF alternative NPV.