Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from assignment or asset equal zero. Internal rate of return is used to evaluate the attractiveness of a project or asset. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be disallowed.
Internal Rate of Return (IRR) Issues
While IRR is a very common metric in estimating a project’s viability, it can be misleading if used alone. Depending on the initial investment costs, a project may have a low IRR but a high NPV, meaning that while the pace at which the company sees returns on that project may be slow, the project may also be adding a great deal of overall value to the company.
A similar issue arises when using IRR to compare projects of unlike lengths. For example, a project of a short duration may have a high IRR, making it appear to be an excellent investment, but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns slowly and steadily, but may add a large amount of value to the corporation over time.
Another issue with IRR is not one strictly inherent to the metric itself, but rather to a common misuse of IRR. People may assume that, when positive cash flows are generated during the course of a project (not at the end), the money will be reinvested at the project’s rate of return. This can rarely be the case. Rather, when positive cash flows are reinvested, it will be at a rate that more resembles the cost of capital. Misconstruing using IRR in this way may lead to the belief that a project is more profitable than it actually is. This, along with the fact that long projects with fluctuating cash flows may have multiple distinct IRR principles, has prompted the use of another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to correct these issues, incorporating cost of principal as the rate at which cash flows are reinvested, and existing as a single value. Because of MIRR’s adjustment of the former issue of IRR, a project’s MIRR will often be considerably lower than the same project’s IRR.