Some Challenges in Using IRR in Decision Support (Part I)

The use of the internal rate of return in decision-making can be rather subtle and may even be misleading.

For example, the decision rule: “For independent projects, accept the project if the IRR is above the required rate of return” is often stated as the core rule. However, the following demonstrates the general principle that the IRR remains the same if all cash flows are reversed in sign:

Reversal of Sign Does Not Change the IRR

It should be clear that IRR is invariant to the reversal in sign of cash flows, since if the sum of the discounted cash flows is zero for one set of cash flows, then it is also zero if the signs are reversed (since negative zero equals zero). Moreover, only one of the two projects can ever make sense to undertake, since if one is profitable for an investor, then its negative is not profitable. Yet, the core rule implies that both projects should be undertaken.

To qualify this core rule, one in fact needs to state that it applies only for cash flow profiles which start negative and are then positive (with no additional changes of sign). The decision-maker’s role in the project must be one of “investor” or “provider” of finds, and not a “receiver” of funds initially.

An analysis of the properties of the IRR and its appropriate use in decision support is covered within our course materials.

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