Challenges of Using Internal Rate of Return (IRR) for Project Comparison

The internal rate of return (IRR) is a popular financial metric used to evaluate the profitability of potential investments. However, when comparing projects with different cash flows, such as those with high initial investments versus low ongoing costs, IRR can present significant challenges. This article explores these challenges and provides guidance on how to use IRR effectively while considering its limitations.

The Limitation of IRR in Distinguishing Cash Flows

One of the primary disadvantages of using IRR is its inability to accurately distinguish between positive and negative cash flows, which can lead to misleading and potentially dangerous conclusions. Consider the two scenarios below:

Standard Business Case Scenario

Imagine a situation where a firm invests a significant amount of money at the beginning, which then yields a steady cash flow over a period of time. In this example, the internal rate of return (IRR) is calculated to be 27%. This seems promising, suggesting a healthy return on investment.

Weird Business Case Scenario

Now, consider a scenario where the firm has an initial positive cash flow, but this is followed by an immediate and substantial loss. Despite this, the IRR calculation still shows a value of 27%. The IRR does not take into account the fact that the company may be losing money in this case.

The issue with IRR in the weird business case is that it cannot distinguish between positive and negative cash flows. This means that in complex cash flow scenarios, IRR might not accurately reflect the overall financial outcome of the project. Therefore, it is essential to be cautious and interpret IRR results in conjunction with other financial metrics.

IRR Does Not Reflect Absolute Profitability

A second significant limitation of IRR is that it does not provide information on the absolute quantum of money being made in a business case. While IRR indicates the internal rate of return, it does not offer insights into the total financial gain or loss.

Let's illustrate this with an example. Consider two scenarios:

Scenario 1: A project with a higher IRR of 27% but involves a small initial investment. The total profit is relatively small.

Scenario 2: A project with a lower IRR (e.g., 15%) but involves a larger initial investment, leading to a higher net present value (NPV).

In Scenario 1, despite the higher IRR, the project might not be as attractive in terms of absolute profitability compared to Scenario 2, where the NPV is significantly higher.

This illustrates that while IRR is a useful tool for selecting projects with potentially higher returns, it is essential to also consider the absolute monetary value generated by a project through methods such as net present value (NPV).

Conclusion and Best Practices

IRR is undoubtedly one of the most useful tools for cash flow analysis in many applications. However, it is crucial to be aware of its limitations and potential pitfalls, especially when comparing projects with differing cash flow patterns.

To effectively use IRR, consider the following best practices:

Always check the total numbers and cash flows to understand the overall financial picture.

Use NPV in conjunction with IRR to evaluate absolute profitability.

Be cautious with scenarios involving complex or negative cash flows.

Consider other financial metrics such as payback period and profitability index.

By following these guidelines, you can ensure that you make well-informed investment decisions based on a comprehensive analysis of the financial health of your projects.