Weaknesses of the IRR Method: The Internal

Weaknesses of the IRR Method: The Internal Rate of Return (IRR) is considered as the discount rate that makes a cash flow's net value equal zero and it's the most useful means of project evaluations. Actually, the IRR method is one of the most widely used methods of measuring project worth as well as economic and financial analysis by many institutions like the World Bank.

This is because this method represents the average earning power of monies used in a project over the entire life of the project making it to be referred to as yield of the investment in certain situations. In most cases, the computation of the internal rate of return method for project evaluation incorporates a trial and error method. The main rule when evaluating a project using this method is to acknowledge all investments in cases where the internal rate of return is higher than the opportunity cost of capital.

Moreover, the internal rate of return is an extremely important measure in assessing the financial flows of money for a specific project. The strength of the IRR method in project evaluation is that it's made up of the wide-scale acceptance of the measure in financial community and is also dependent on discounted cash flows. The other advantage of this method is that the measure in the financial community also acknowledges the time value of money. Consequently, this measure offers excellent guidance of the value of a project when used properly.

However, the use of the internal rate of return in project evaluation also has several weaknesses including: Multiple Rates of Return: This is one of the major weaknesses or pitfalls of using the internal rate of return method in the evaluation of projects since it's likely to have multiple or no IRRs. The possibility of the project to have multiple IRRs or no IRR occurs when the project being evaluated contains more than a single change in sign for the cash flow stream.

Therefore, the internal rate of return method is not suitable for evaluating projects with a non-typical allocation of cash flows. Notably, there are additional difficulties regarding selection of projects when the results of calculations are more than one internal rate of return value. Changes in Discount Rates: The rule of using this method in evaluation of projects is the acceptance of projects which the IRR is higher than the weighed average cost of capital or the opportunity cost of capital.

This rule presents one of the weaknesses of this method since it's likely to result in impossible comparisons if this discount rate changes annually. IRRs Do Not Add Up: When using this method for evaluation of projects, calculations are dependent on the non-linear function. Therefore, this is one of the weaknesses of this method because it doesn't contain any additive feature making it impossible to sum IRRs of various projects. Unlike the Net Present Value (NPV) method, it impossible to add one project to an existing project for.