QuickBooks 2014: Problems with the IRR Measurement
The internal rate of return (IRR) measurement makes a lot of intuitive sense. Capital budgeting is burdensome enough without being weighed down further by some tricky, abstract, theoretical capital budgeting tool such as the net present value.
You should know, however, that the internal rate of return has some practical weaknesses, which is why people with MBAs and PhDs in business and finance greatly prefer the net present value measure.
Knowing about the weaknesses enables you to more safely use the IRR tool. On the other hand, knowing about the weaknesses may also make you choose to just bear with the abstractness of the net present value model and use it instead. Anyway, here are the weaknesses:
The IRR measure doesn’t always identify the best investment. In other words, you sometimes can’t pick the investment with the highest IRR and get the most profitable investment.
As an extreme example, suppose that you have $100,000 to invest. Would you rather invest only $10,000 of your money in something earning 20 percent annually or look at something earning 18 percent annually in which you can invest the entire $100,000? Do you see the difference?
Twenty percent of $10,000 isn’t going to be as good as 18 percent of $100,000. Unfortunately, the IRR measure — by focusing on the percentage return — sometimes causes people to lose sight of the dollars of profit, which obviously is what you really want to maximize.
By comparison, the net present value does calculate a straight dollar profit amount. By picking an investment with the highest net present value, you’re picking the investment that delivers the most dollars and profits.
The IRR measure doesn’t recognize reinvestment risk very well. This sounds like another mumble-jumble problem, but it’s actually a pretty important one.
Suppose that you have a million dollars to invest. Would you rather pick a 1-year investment (Option A) that earns 30 percent or a 20-year investment (Option B) that earns 20 percent? At first blush, a 30 percent investment seems like a pretty good one. Obviously, 30 percent is a lot more than 20 percent.
However, here’s what you have to consider: Where are you going to invest the money from Option A one year from now, when that investment liquidates? The key is that you have to be able to invest the $1.3 million (which is what you get from Option A one year from now) in something that beats the Option B investment.
In other words, you have to think about that reinvestment risk for your investments. The IRR doesn’t really do this. By comparison, the net present value does. Implicitly, the net present value assumes that you can reinvest money at the discount rate used in the calculation. In essence, the discount rate is the going rate that you can earn on your other capital investments, so it automatically factors in reinvestment.
The IRR measure doesn’t always produce a solution or a unique solution. The IRR formula isn’t solvable, for example, when the cash flows don’t really look like investment cash flows.
If you have an investment that generates cash only because there’s no initial cash outlay, you can’t calculate an internal rate of return. But such an investment, obviously, is a very good deal that you should select. A related problem is that sometimes, the IRR formula can’t be uniquely solved.
This business about no unique solution stems from a little bit of mathematical weirdness. (The problem is that technically, an IRR formula is an nth root polynomial equation with up to nth possible solutions!) This multiple-solutions weirdness pops up when you have the cash flow signs changing over the years that the investment is held.
In the case of the office-building investment, only one sign change exists. In year 2, the cash flow is negative. And in year 3, the cash flow becomes positive and stays positive. This means that the building has one single internal rate of return.
If in some years the cash flow was positive and in some years the cash flow was negative, however, each of these flips from negative to positive cash value, or vice versa, indicating another solution to the IRR formula.
The important point is that by using the net present value formula, you always know that a solution exists and that it’s the single unique solution, given a particular discount rate.