IRR Problems

Several problems are associated with IRR :

Reinvestment Assumption

In the IRR calculation, cash inflows from the project are assumed to be reinvested at the Internal Rate of Return. However, cash inflows may not be able to be reinvested at the assumed rate. If the cash inflows cannot be reinvested at the IRR, then the calculated IRR will not represent the project’s true rate of return.

Multiple IRRs for Nonconventional Projects

A conventional project begins with a cash outflow followed by several cash inflows. In other words, the direction of the cash flow changes just once, from negative in Year 0 to positive in Year 1, and remains positive throughout the remainder of the project’s life. However, not all projects follow this conventional pattern. Cash flows might change in different directions over the course of many years, alternating between positive and negative.

If a project has a negative expected cash flow or flows after Year 0, for instance if an additional investment is required during a subsequent year, the project is called a nonconventional project. A nonconventional project may have more than one IRR because more than one discount rate will cause the project’s NPV to be zero. The number of IRRs will be equal to the number of sign changes in the cash flows, including the sign change following the initial investment in Year 0. In other words, a conventional project will have only one IRR because it has only one sign change: the change from a negative cash flow in Year 0 to a positive cash flow in Year 1. But a nonconventional project that has a sign change after the initial investment because of a negative cash flow in a subsequent year will actually have three sign changes and three IRRs: the first sign change when the negative cash flow in Year 0 becomes a positive cash flow in Year 1, and then two more sign changes. One of the additional sign changes takes place when the cash flow becomes negative in the subsequent year and the other additional sign change takes place when the cash flow again becomes positive during a later year.

Multiple IRRs are usually not a problem, since generally only one of the IRRs will fall within reasonable parameters, while the other IRRs can vary widely, such as 500% or -50%, or even as high as 10,000%. However, if the multiple solutions cause a financial calculator to return an error message, then the IRR cannot be calculated on the financial calculator.

Thus, if a project has more than one change in annual cash flow direction, it is better to evaluate it on the basis of its NPV rather than on its IRR.

Mutually Exclusive Projects

Sometimes project options are mutually exclusive; that is, a company can choose only one project to the exclusion of all others. When projects are mutually exclusive, they frequently are of different sizes or have different cash flow patterns, and the information provided by the IRR is not very useful for decision making.