The main advantage of IRR method is that the information it provides is more easily understood by managers than NPV, especially non-financial managers. It gives a relative measure of the value of a proposed investment in the form of a percentage which can be compared with the company’s cost of capital or the rates of interest and inflation.
IRR is a discounted cash flow method and so takes account of the time value of money: the concept that $1 received today is not equal to $1 received in the future..
IRR considers cash flows over the whole of the project life and is sensitive to both the amount and the timing of cash flows.
IRR ignores the relative sizes of investments. It therefore does not measure the absolute increase in company value, and therefore shareholder wealth, which will be created by an investment.
Where cash flow patterns are non-conventional, for example cash flows change from positive to negative during the life of the project, there may be several IRRs which decision makers must be aware of to avoid making the wrong decision. When discount rates are expected to differ over the life of the project, such variations can be incorporated easily into NPV calculations, but not into IRR calculations.
Mutually exclusive projects are two or more projects from which only one can be chosen. Examples include methods can, however, give conflicting rankings as to which project should be given priority. Where there is a conflict, NPV always offers the technically correct investment advice.
Despite the advantages of the NPV method over the IRR method, the IRR method is widely used in practice.
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