What are the pros and cons of using IRR as a decision criterion? (2024)

If you are evaluating different investment projects, you may have heard of the internal rate of return (IRR) as a way to compare their profitability. The IRR is the interest rate that makes the net present value (NPV) of a project's cash flows equal to zero. In other words, it is the rate of return that the project generates over its lifetime. But is the IRR a reliable and accurate measure of a project's value? In this article, we will explore some of the advantages and disadvantages of using IRR as a decision criterion.

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• Dr. David Duren Accounting and Business Professional in Higher Education

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One of the main benefits of using IRR is that it is easy to understand and communicate. Unlike other methods, such as NPV or payback period, the IRR does not depend on the cost of capital or the time value of money. It simply tells you the percentage return that a project offers, which can be compared to other projects or to a required rate of return. For example, if a project has an IRR of 15%, it means that it will generate 15% more than the initial investment over its lifetime. This can be a useful way to communicate the attractiveness of a project to investors, managers, or stakeholders.

However, using IRR as a decision criterion can also have some drawbacks. One of the main problems with IRR is that it can be misleading or inconsistent in some situations. For instance, if a project has multiple cash flows with different signs, such as positive and negative cash flows, it may have more than one IRR, which can create confusion and ambiguity. Another issue is that the IRR may not reflect the true profitability of a project if it has different scales or durations. For example, a project with a higher IRR may not necessarily be better than a project with a lower IRR if the former has a smaller initial investment or a shorter lifespan. In these cases, using NPV or profitability index may be more appropriate.

Another limitation of using IRR as a decision criterion is that it assumes that the cash flows generated by a project can be reinvested at the same rate as the IRR. This may not be realistic or feasible in some scenarios, especially if the IRR is very high or low, or if the market conditions change over time. For example, if a project has an IRR of 25%, it means that the cash flows can be reinvested at 25% every year, which may not be possible or desirable. In contrast, using NPV or modified internal rate of return (MIRR) takes into account the reinvestment rate of the cash flows, which may be more realistic and accurate.

A final drawback of using IRR as a decision criterion is that it does not consider the risk or uncertainty of a project's cash flows. The IRR assumes that the cash flows are known and fixed, and that they will occur as expected. However, this may not be the case in reality, as there may be fluctuations, delays, or changes in the cash flows due to various factors, such as market demand, competition, regulation, or inflation. These factors can affect the actual return and value of a project, and may require adjustments or revisions in the analysis. Therefore, using IRR alone may not capture the full picture of a project's performance and riskiness. It may be better to use other methods, such as sensitivity analysis, scenario analysis, or Monte Carlo simulation, to account for the uncertainty and variability of the cash flows.

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Cash Flow Analysis