IRR: A Blind Guide

Abstract

Over the past 60 years the internal rate of return (IRR) has become a major tool in investment evaluation. Many executives prefer it to net present value (NPV), presumably because they can more easily comprehend a percentage measure. This article demonstrates that, except in the rare case of an investment that is followed by a single cash return, IRR suffers from a definitional quandary. Is it an intrinsic measure, defined only in terms of itself, or is it defined by the efforts of active investors? Additionally, the article explains significant problems with the measure - reinvestment issues, multiple IRRs, timing problems, problems of choice among unequal investment opportunities, and practical difficulties with multiple discount rates. IRR is a blind guide because its definition is in doubt and because of its many practical problems.

Cost‐benefit Analysis and the Controversial Reinvestment Assumption in IRR and NPV Estimates: Some New Evidence Against Reinvestment Assumption

“…When the intermediate income with interest is reinvested and accumulated until the maturity of the investment or life of the project, the MIRR collapses to IRR. A similar situation is explained by Kierulff () and accordingly, when the intermediate income is reinvested the IRR becomes a special case of MIRR or external rate of return.…”

“…When the intermediate income with interest is reinvested and accumulated until the maturity of the investment or life of the project, the MIRR collapses to IRR. A similar situation is explained by Kierulff (2012) and accordingly, when the intermediate income is reinvested the IRR becomes a special case of MIRR or external rate of return. Cheremushkin (2012) argued that compounding to arrive at the FV in MIRR and discounting to estimate the IRR, at financing rate, will cancel each other, and thus MIRR ending up with traditional IRR.…”

“…The IRR estimate is also not influenced by the reinvestment both under normal and non-normal NCFs, and therefore the reinvestment assumption is not valid. 3 As discussed earlier, MIRR collapse into IRR under the WR scenario (see also Kierulff (2012) and Cheremushkin (2012)). The estimated ROIC, under the WR-NCF, above the IRR must be from the NCIF generated from reinvestment of divested capital income elsewhere.…”

“…A number of academic articles argue that the IRR does implicitly assume reinvestment of interim cash flows (e.g. Plath & Kennedy, 1994;Velez-Pareja, 2000;Keown et al 2004;Girma & McClure, 2004;Shirvani & Wilbratte, 2009;Arnold & Nixon, 2011;Walker et al 2010, Kierulff, 2012Murugesan 2013). There are other papers that reject the existence of the reinvestment assumption (Dudley, 1972;Carlson et al, 1974;Beidleman, 1984;Keef & Roush, 2001;Johnston et al, 2002;Ross et al 2008;Rich & Rose, 2014;Schmidt, 2014).…”

Simulation of economic effect on electricity democracy based on clean energy at UMKM’S IPP in Indonesia

“…Bhandari, Shyam B [8], introduces the discounted payback period criterion for small business capital budgeting decisions; properties and limitations of the traditional payback technique; discussion of the discounted payback approach; Comparison of the payback methods with other capital budgeting techniques According to Kierulff, Herbert [9], the article explains significant problems with the measurement of reinvestment issues, multiple IRRs, timing problems, problems of choice among unequal investment opportunities, and practical difficulties with multiple discount rates. And according to Bhattacharyya, Nalinaksha [10], establishes the validity of the IRR interpretation as returns earned on funds still internally invested in the project.…”