Some Challenges in Using IRR (Part II)

The IRR rule can also be misleading or inapplicable if the cash flow profiles change sign and if one relies on the default settings for the Excel IRR function.

Consider a “base case” project where one could invest $100 this year to earn $120 next year (cash profile -100, 120), so that the IRR is 20%.

Now if one could delay $30 of the initial investment for two years, the cash profile would be -70, 120, -30. Not surprisingly the IRR has increased to 41%.

If one could delay even more of the initial investment (say $70), so that the cash flow profile is -30, 120, -70, then the Excel IRR function will be default show a value of -29%. In other words, it appears that the ability to delay the investment (but not the return) has reduced IRR, and potentially made the project unprofitable.

In fact, due to the two change of sign in the cash flow profile, there are two values for the internal-rate-of-return. These are -29% and 229%. However, the IRR function is calculated by an iterative process that uses a default guess of 10%. So, the default application of the function returns an inappropriate figure. The “correct” solution can be found (if one is aware of it) but using the function with an alternative initial guess.

The presence of the potential for multiple changes of sign in a cash flow profile can occur in practical applications where projects have finite lives with abandonment costs at the end (e.g. natural resources, project finance in general).

The IRR therefore be problematic is a measure, since one may even be aware of multiple values, or may have no way of immediately knowing which of the multiple figures is the appropriate one to use (in the absence of a clear reference “base case” project).

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