Internal Rate of Return(IRR) and its Pitfalls (Basic)(Corporate Finance)

Internal Rate of Return(IRR) is the interest at which the net present value of the all-cash flows from a project or investment equals zero. If the IRR of the project is greater than the required rate of return, the project is feasible else not. It is the rate at which the project break even. Below is the numerical example for calculating the IRR in a hypothetical scenario.

Annual Cash Flows	Year
-$1,000,000	0
$200,000	1
$350,000	2
$0	3
$900,000	4
$120,000	5
$50,000	6

IRR = Discounting rate which makes the NPV zero.

(CF0) +	CF1	+	CF2	+	CFn			= 0
	( 1 + IRR )1		( 1 + IRR )2		( 1 + IRR )n

=-1000000/(1+r)^0+200000/(1+r)^1+350000/(1+r)^2+0/(1+r)^3+900000/(1+r)^4+120000/(1+r)^5+50000/(1+r)^6

= 16.27%

Therefore, the IRR of the project is 16.27%, here if the cost of capital is less than the IRR than the project could be accepted otherwise not. If the cost of capital is 17%, the project would be rejected. 

But indeed, the IRR comes across lots of drawbacks, the IRR does not give the absolute value of the return as determined by the Net Present Value(NPV). For example, the IRR of 15% alone does not tell if its 15% of $1000 0r 15% of $10000. Comparing two projects with different duration is not useful from IRR, some of them are briefly described below.

·       Lending or borrowing

Project	Co	C1	IRR	NPV@ 10%
A	-100	150	50%	$36.36
B	100	-150	50%	($36.36)

In the example above, we can see that both the project A and B have identical IRR, i.e. 50%. The project A is borrowing at 50% and project B is lending at 50%. But in reality, the investor wants to borrow at less price and lend at the higher price. If we see the NPV of B, it is negative. Even though IRR is indifferent, the NPV criteria rejects the project B.

·       Multiple IRR

Project	Co	C1	…………….	C9	C10
A	-30	10		10	-65

Sometimes whenever there is a multiple cash outflow, the projects generate multiple IRR making difficult to make the rational decision. In the example above, the IRRs are 3.50% and 19.54%. these complexities appears whenever there are more than one cash outflow.

·       Mutually exclusive projects

project	C0	C1	IRR%	NPV @ 10%
A	-10000	20000	100%	$8,181.82
B	-20000	35000	75%	$11,818.18
Incremental
C	-10000	15000	50%	$3,636.36

Here initially it feels that project A is better than project B, so often the manager could be tempted to reject B as its IRR is less than of A’s.  But if the incremental value of investment for B(i.e. 10000 additional investment in B and gain of additional 15000) is analyzed than C comes with positive IRR and NPV. We should accept project B.

Hence from the above, we can conclude that IRR, though is mostly issued method of capital budgeting, it is not free from numerous pitfalls. So, the best approach to make an investment decision is by using NPV as well as IRR along with discounted PBP.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2016). Principles of Corporate Finance. McGraw Hill Education.