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Interim Cash Flows and Their Impact on IRR in Capital Budgeting
Meaning and Importance of Interim Cash Flows
Intermediate cash flows are the regular cash receipts and payments that are likely to be realized
from a project at different intervals before the termination of the project. These cash flows are
important because they encompass actual money returns on investments in a project during the
duration of the project while appreciating the value of stakes or stocks at certain fixed intervals
of time or, at best, at the end of the entire project's lifecycle. They may contain sales and
operating revenue, expenditure of constantly required expenses, or pro rata repayments of
capital.
Regarding the evaluation of cash flows, it is essential in capital budgeting to correct the interim
cash flow assessment. These documents are crucial in establishing the feasibility and profitability
of any project. Failing to appreciate these flows causes one to make wrong investments. For
example, overestimating the reinvestment rate of these interim cash flows will grossly skew a
project's projected earnings.
The Effect on the Reliability of IRR
The IRR, or internal rate of return, is an essential tool for evaluating the profitability of
investments in capital budgeting. It is the discount rate that brings the Net Present Value (NPV)
of all a project's cash flows virtually to zero. However, there are quite a few problems with IRR,
among which the following critical flaws can be mentioned: The assumptions regarding interim
cash flows.
1. Reinvestment Rate Assumption: IRR also implies that interim cash flows can be reinvested at
IRR itself, which is not true in most cases and is often unrealistic. In reality, these interim cash
flows are likely to be reinvested at a lower rate than the project's IRR, which approximates the
cost of capital rate. This is because such a situation may result in an overestimate of the true
return of a given project.
2. Distorted Comparisons: Based on the explanations above, firms with high interim cash flows
are sensitive to IRR calculations. What is essential about these cash flows is that if they occur
early in the project's life, the effect of changes in the reinvestment rate assumption is even more
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pronounced, and the calculated IRR is overstated. This conceals the actual magnitude of work in
the project and, thus, makes the work outlook more attractive than it is.
3. Misleading Decision-Making: Due to the use of IRR, managers are likely to select projects
that yield high IRRs. However, such projects may only sometimes be beneficial for creating real
value. The article has an example of where they showed that projects endowed with high IRR all
had lower accurate returns when the rate of reinvestment was carried out realistically.
Conclusion on the Future of IRR as a Project Evaluation Method
Due to the simplicity and popularity of the technique, IRR will continue to be used consistently
in capital budgeting. Nevertheless, certain inherent shortcomings should be considered when this
strategy is applied. While using IRR is essential, it is recommended that financial managers
consider other measures, such as NPV, which present the actual value of a project given the fact
that it assumes a reinvestment rate equal to the firm's cost of capital.
However, it is necessary to use the modified internal rate of return (IRBB) instead of the actual
one because it admits realistic reinvestment rates. Managers can make better decisions using
MIRR by identifying and avoiding the main problem with the standard IRR.
Despite its simplicity and acceptance by business and academia, MIRR will continue to be used
due to its simplicity and acceptance; however, managers should use it alongside other methods
because of its shortcomings. Strategies that will ensure that actual working capital has been
reinvested into the business and consequently improve the reliability of capital budgeting
decisions shall be addressed.
