The Drawbacks of Internal Rate of Return (IRR)
Business investment can be a complicated endeavor. While individual investors can compare bond yields or earnings-per-share of stock in order to pick the ideal investment for their portfolio, businesses looking at the potential profits from different projects aren’t often comparing apples with apples.
How do you compare an investment in new manufacturing equipment versus an investment in hiring 100 new workers? Or make the decision between opening a new office or purchasing a fleet of work trucks? No simple metric exists to compare projects of varying scopes like this.
Since no single metric will suffice, sophisticated investors turn to a more complex equation: internal rate of return, or IRR. IRR sets the net present value (NPV) of an investment to zero in order to compare different investment opportunities on the same barometer.
The result is a single return rate that can be compared across different investments in order for the most efficient one to be selected. However, despite the benefits of this type of analysis, using IRR has drawbacks and shouldn’t be used as the sole criteria for evaluating potential investments.
How Does Internal Rate of Return (IRR) Work?
IRR measures discounted cash flows to create an annualized rate of return on a project or investment that can then be used to compare other projects.
In order to use IRR, the investment’s net present value (NPV) is reduced to zero, so that the potential can be measured on its own. Without taking NPV to zero, the value of the firm comes into play, which can make a comparison across various investments difficult.
One of the biggest benefits of using IRR is that the hurdle rate, meaning the cost of funding, doesn’t need to be factored in. Hurdle rate can often be viewed as the predetermined bar that an investment must surpass in order to be profitable to the company.
If the hurdle rate is 10% and the investment has an expected IRR of 9%, it won’t be a viable option for the company, even if the IRR is superior to other projects.
IRR is a complex formula that requires interpretation of the initial investment costs, the time periods over which the investment will span, and the cash flow produced in each individual time period. A calculator or Excel spreadsheet is usually required to compute the formula; this isn’t a metric for ‘back of the napkin’ analysis.
Cons of Using IRR In Financial Projections
IRR can be a useful tool for businesses, but isn’t the be-all, end-all of investment analysis. A number of limitations hinder the ability of the metric to produce important information on its own — here are a few of the biggest ones.
The Scale of Investments Isn’t Factored In
No two investments are created equal; that’s why we have metrics like IRR in the first place. But while IRR is useful in measuring the expected annualized returns of different projects, it fails to grasp the scale of the projects it evaluates.
For example, consider a $100,000 investment with an 8% IRR and a $50,000 investment with a 12% IRR. The $50,000 investment produces a higher rate of return but nets less in actual dollars than the $100,000 investment with the lower rate. An 8% return on $100,000 generates $8,000 in profit while 12% on $50,000 is only $6,000 in total profit.
Investment Term Length Ignored
Short-term and long-term investments must both be considered when deploying capital, but IRR doesn’t factor in the term length that capital will be invested.
Let’s consider another example: two $50,000 investments both have a 12% IRR. But Investment A has a five-year term while Investment B has a three-year term. IRR considers these investments to have equal returns, but in real dollars, the longer investment has more time to generate returns and should outproduce the shorter-term investment.
Requires a Calculator
Some financial metrics can be simple to calculate. Looking for a company’s P/E Ratio? Just divide the stock price by the firm’s earnings per share to find the 12-month rate.
But IRR is a far more complex equation, requiring the calculation of cash flow over multiple time frames with NPV adjusted to zero. As mentioned above, IRR isn’t a formula to do by hand — it will require an Excel model or an online IRR calculator.
IRR is an Annualized Percentage Only
IRR is useful for comparing return rates across various investments and asset classes, but the number produced is an annualized rate that can often be poorly illustrative of the total value a project can bring in.
For example, an investment with an IRR of 8% is once that will grow 8% annually for the duration of the term. But what was the starting point? How much capital was invested at the start? And what other investments must be considered in conjunction with the one under analysis?
Think about a company that analyzes two projects and see that adding a fleet of work trucks offers a better IRR than purchasing new factory equipment. But IRR exists in a vacuum — what are the costs of maintaining and fueling the trucks? And where will they be stored when not in use? IRR doesn’t consider these factors, just the annualized growth rate of the investment.
Combining IRR with Other Metrics
IRR is certainly a helpful tool when comparing different types of investments, but it can’t be the only metric used in the analysis. Like most financial tools, it’s part of a larger toolbox that can be used to view different projects from different angles.
For example, a more comprehensive analysis can be done by combining IRR with an overall value metric like Return on Investment (ROI). IRR and ROI will look the same when measured over a single year, but ROI measures the total return of an investment while IRR looks like the annualized rate. Using both together could offer a more conclusive look at the total value an investment brings to a company, depending on the investment.