IRR (Internal rate of return) is the valuable technique to evaluate capital intensive project. This is useful when the cash flows are following the conventional pattern of cash flows. Be conventional pattern, we mean that in initial years, cash outflows are incurring while in rest of the years, cash inflows arise.
But, in reality this is not the case always. In undertaking a long term project, cash outflows arise in initial years and in subsequent years as well. This causes more than one IRR in the project which is a severe problem for the decision maker. So, IRR is useful only when all the negative cash flows occur before the positive cash flows.
Example
ABC is engaged in the production of textile bed sheet. It is considering investing in a capital investing project that would require cash flows as follows:
| Year | 1 | 2 | 3 | 4 | 5 | 6 |
| Cash Flow | -145 | 100 | 100 | 100 | 100 | -275 |
As you can see that the cash flows of this project is not like a normal one as cash outflows are occurring at the beginning and at the end of the project. In order to calculate IRR of this project, we can use the IRR function formula of MS Excel. As you know that, we use some sort of guess work in finding out the project’s IRR. We will do the same here for IRR calculation. Open MS Excel and use the following formula:
IRR1 = IRR(F3:F8,0.1) = 9 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}
IRR2 = IRR(F3:F8,0.3) = 27 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}
The cash flows are entered into cells F3 to F8. The calculation yields out two IRR which is not good for decision making. The difference between two rates is also very high. This multiple IRR forces financial analyst to take decision over NPV basis as this is the most reliable evaluation method under the given circumstances.