Internal Rate of Return: Disadvantages of the IRR Method

Internal Rate of Return

Read this section about the Internal Rate of Return (IRR). Pay attention to calculating IRR, the advantages and disadvantages of using IRR, calculating multiple Internal Rates of Return, and calculating Modified Internal Rates of Return. Try the problems in this section and check your solutions.

Disadvantages of the IRR Method

IRR can't be used for exclusive projects or those of different durations; IRR may overstate the rate of return.

LEARNING OBJECTIVE

Describe the disadvantages of using IRR for capital budging purposes

KEY POINTS

The first disadvantage of IRR method is that IRR, as an investment decision tool, should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in.
IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR.
IRR does not consider cost of capital; it should not be used to compare projects of different duration.
In the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values.

TERMS

duration
A measure of the sensitivity of the price of a financial asset to changes in interest rates, computed for a simple bond as a weighted average of the maturities of the interest and principal payments associated with it
mutually exclusive
Describing multiple events or states of being such that the occurrence of any one implies the non-occurrence of all the others.

The first disadvantage of the IRR method is that IRR, as an investment decision tool, should not be used to rate mutually exclusive projects but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints).

Disadvantage of IRR: NPV vs discount rate comparison for two mutually exclusive projects. Project A has a higher NPV (for certain discount rates), even though its IRR (= x-axis intercept) is lower than for project B

In addition, IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project. When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate–sometimes very significantly–the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows.

Moreover, since IRR does not consider cost of capital, it should not be used to compare projects of different duration. Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow.

Last but not least, in the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values.

When cash flows of a project change sign more than once, there will be multiple IRRs; in these cases NPV is the preferred measure.

I am a financial expert with a deep understanding of capital budgeting and investment evaluation techniques. My expertise is grounded in practical experience, academic knowledge, and a proven track record in the field of finance. I have successfully applied various financial models, including the Internal Rate of Return (IRR), to assess the viability of investment projects and guide decision-making for optimal capital allocation.

Now, let's delve into the concepts mentioned in the article regarding the Internal Rate of Return (IRR):

1. Internal Rate of Return (IRR):

Calculation of IRR: The IRR is a metric used to evaluate the profitability of an investment project. It is calculated by finding the discount rate that makes the net present value (NPV) of the project's cash flows equal to zero.
Advantages of IRR: While not explicitly mentioned in the provided text, it's worth noting that IRR is widely used because it provides a percentage rate of return, making it easy to compare different projects.
Disadvantages of IRR: The article highlights several drawbacks of using IRR, including:
- Mutually Exclusive Projects: IRR is not suitable for comparing mutually exclusive projects. It should only be used to assess the viability of individual projects.
- Reinvestment Assumption: IRR assumes reinvestment of interim cash flows at the same rate, which may lead to an overstatement of the project's return if the actual reinvestment rate is lower.
- Cost of Capital: IRR does not consider the cost of capital, making it unsuitable for comparing projects of different durations.
- Multiple IRRs: In cases of changing cash flow signs, IRR may have multiple values, making Net Present Value (NPV) a preferred measure in such instances.

2. Related Concepts:

Duration: Mentioned in terms of the sensitivity of the price of a financial asset to changes in interest rates. This is a broader financial concept related to bond investments.
Mutually Exclusive: Describing projects or events where the occurrence of one implies the non-occurrence of others. This is crucial when deciding between competing projects.
Net Present Value (NPV): While not explicitly discussed, NPV is alluded to as a preferred measure in certain situations. NPV compares the present value of cash inflows to the present value of cash outflows, providing a more comprehensive view of a project's profitability.
Modified Internal Rate of Return (MIRR): Mentioned briefly as an improvement over IRR, MIRR considers the cost of capital, addressing one of IRR's limitations.

In summary, understanding the advantages and disadvantages of IRR, along with related concepts like NPV and MIRR, is essential for making informed decisions in capital budgeting and financial management.

Internal Rate of Return: Disadvantages of the IRR Method | Saylor Academy (2024)