Internal Rate of Return: A Cautionary Tale

Tempted by a project with high internal rates of return? Better check those
interim cash flows again.
The McKinsey Quarterly - McKinsey & Co.
October 20, 2004

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Maybe finance managers just enjoy living on the edge. What else would explain
their weakness for using the internal rate of return (IRR) to assess capital projects?
For decades, finance textbooks and academics have warned that typical IRR
calculations build in reinvestment assumptions that make bad projects look better
and good ones look great. Yet as recently as 1999, academic research found that
three-quarters of CFOs always or almost always use IRR when evaluating capital
projects. (John Robert Graham and Campbell R. Harvey, "The Theory and Practice
of Corporate Finance: Evidence from the Field," Duke University working paper
presented at the 2001 annual meeting of the American Finance Association, New
Orleans.)

Our own research underlined this proclivity to risky behavior. In an informal survey
of 30 executives at corporations, hedge funds, and venture capital firms, we found
only 6 who were fully aware of IRR's most critical deficiencies. Our next surprise
came when we reanalyzed some two dozen actual investments that one company
made on the basis of attractive internal rates of return. If the IRR calculated to
justify these investment decisions had been corrected for the measure's natural
flaws, management's prioritization of its projects, as well as its view of their overall
attractiveness, would have changed considerably.

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So why do finance pros continue to do what they know they shouldn't? IRR does
have its allure, offering what seems to be a straightforward comparison of, say, the
30 percent annual return of a specific project with the 8 or 18 percent rate that
most people pay on their car loans or credit cards. That ease of comparison seems
to outweigh what most managers view as largely technical deficiencies that create
immaterial distortions in relatively isolated circumstances.

Admittedly, some of the measure's deficiencies are technical, even arcane, but the
most dangerous problems with IRR are neither isolated nor immaterial, and they
can have serious implications for capital budget managers. When managers decide
to finance only the projects with the highest IRRs, they may be looking at the most
distorted calculations — and thereby destroying shareholder value by selecting the
wrong projects altogether. Companies also risk creating unrealistic expectations for
themselves and for shareholders, potentially confusing investor communications
and inflating managerial rewards. (As a result of an arcane mathematical problem,
IRR can generate two very different values for the same project when future cash
flows switch from negative to positive (or positive to negative). Also, since IRR is
expressed as a percentage, it can make small projects appear more attractive than
large ones, even though large projects with lower IRRs can be more attractive on
an NPV basis than smaller projects with higher IRRs.)

We believe that managers must either avoid using IRR entirely or at least make
adjustments for the measure's most dangerous assumption: that interim cash flows
will be reinvested at the same high rates of return.

The Trouble with IRR

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. In this case, the calculation implicitly takes credit for these additional
projects. Calculations of net present value (NPV), by contrast, generally assume
only that a company can earn its cost of capital on interim cash flows, leaving any
future incremental project value with those future projects.

IRR's assumptions about reinvestment can lead to major capital budget distortions.
Consider a hypothetical assessment of two different, mutually exclusive projects, A
and B, with identical cash flows, risk levels, and durations — as well as identical IRR
values of 41 percent. Using IRR as the decision yardstick, an executive would feel
confidence in being indifferent toward choosing between the two projects. However,
it would be a mistake to select either project without examining the relevant
reinvestment rate for interim cash flows. Suppose that Project B's interim cash
flows could be redeployed only at a typical 8 percent cost of capital, while Project
A's cash flows could be invested in an attractive follow-on project expected to
generate a 41 percent annual return. In that case, Project A is unambiguously
preferable.

Even if the interim cash flows really could be reinvested at the IRR, very few
practitioners would argue that the value of future investments should be
commingled with the value of the project being evaluated. Most practitioners would
agree that a company's cost of capital — by definition, the return available
elsewhere to its shareholders on a similarly risky investment — is a clearer and
more logical rate to assume for reinvestments of interim project cash flows.