Internal Rate of Return (IRR) is an important tool in evaluating the profitability of projects and investments. It serves as a benchmark, comparing a project's expected return against the company's required rate of return (RRR), which reflects the minimum acceptable return considering risk and alternatives. When the IRR exceeds the RRR, the project is typically accepted as it is expected to enhance shareholder value.
However, IRR has limitations. It can be misleading when comparing projects with different durations or capital requirements, so it should be used alongside other metrics like Net Present Value (NPV) and Payback Period for a more comprehensive analysis.
Two conditions must be met for accurate decision-making: the project's cash flows should be conventional (initial outflow followed by positive inflows), and the project should be mutually exclusive, meaning its acceptance shouldn't affect other projects. Problems arise when these conditions aren't met, as IRR may become unreliable or provide multiple solutions.
Additionally, comparing multiple investments using only IRR can lead to incorrect conclusions, making it crucial to use this method carefully with other financial metrics such as NPV.
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