cals - The limitations of IRR when evaluating an investment opportunity
- Corporate Finance

The limitations of IRR when evaluating an investment opportunity

Budgeting is always a tricky issue. In most companies, there are always two budgets for a project or a department – bottoms-up and top-down. Bottoms-up budget is obtained by adding each component/task/sub-department and tallying up the projected expenses for each. Top-down budget is allocated by the senior management to a department or project.

In most scenarios, you have to take both these figures and find a middle point. That is the ideal case, and works in companies where the top-down budget is a range rather than a fixed cap. There are however companies where top-down budgets are often caps and you cannot exceed them. In these companies, the employee who has to finalize the budget often faces the most difficult job.

When you are doing capital budgeting for evaluating an investment project, you have to factor in some key variables that are decisive. These include things such as the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback period. These are the main variables that determine where a project is worth embarking on.

cals2 - The limitations of IRR when evaluating an investment opportunity

During a recent project of ours where we advised one of our clients on an expansion opportunity in Gas Hills, Central Wyoming, there was a question on whether to use the NPV or the IRR as the decisive factor. This was a scenario where the time horizon was more than 15 years, a substantial period of time. The cashflows were also expected to fluctuate significantly between T0 and the payback period. As a result, we prioritized NPV over IRR.

The main reason for this was in cases of longer payback and unpredictable cashflows, IRR is too simplified a metric for evaluating an investment. NPV, however, can be applied to all situations. Furthermore, IRR uses a single discount rate which may not be valid for longer timeframes. Project managers that focus too much on IRR have to understand such limits. We prioritize NPV in most cases.

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