Key takeaways
– The IRR rule: accept a project if its IRR exceeds the required return (hurdle rate or cost of capital); reject it if IRR is below that rate.
– IRR is the discount rate that makes the net present value (NPV) of a project’s cash flows equal zero.
– IRR is easy to compute in a spreadsheet and accounts for time value of money, but it has important limitations (reinvestment assumptions, scale issues, multiple-IRR problems).
– Best practice: use IRR alongside NPV, MIRR, sensitivity analysis, and strategic judgment.
Understanding the IRR rule
– Definition: IRR is the annualized effective return at which the present value of future cash inflows equals the initial outlay (NPV = 0).
– Decision rule (independent projects): Accept if IRR > required return (hurdle or cost of capital); reject if IRR 10%), reject B (5% hurdle and NPV > 0.
• For mutually exclusive projects: prefer the project with the higher NPV (even if IRR is lower).
6. Check for red flags:
• Multiple sign changes in cash flows → compute MIRR or rely on NPV.
• Large disparity in project sizes → check NPVs and consider Profitability Index (PI = NPV / initial investment).
7. Run sensitivity and scenario analyses on key inputs (sales, margins, capex, terminal value).
8. Consider strategic, operational, or competitive factors that are not captured by IRR/NPV.
9. Document assumptions and carry out post-investment monitoring (actual vs. projected cash flows).
Using MIRR to fix reinvestment assumptions
– MIRR formula in spreadsheets: =MIRR(values, finance_rate, reinvest_rate)
– Typical practice: use finance_rate = cost of borrowing (or WACC), reinvest_rate = firm’s reinvestment rate or WACC; MIRR usually gives a single, more realistic return.
When companies don’t follow the IRR rule
– Firms sometimes accept projects with IRR below the hurdle for strategic reasons (market entry, regulatory compliance, blocking competitors, or long-term growth).
– Conversely, a high-IRR project might be rejected because of operational constraints, risk profile, or capital rationing.
Bottom line
IRR is a convenient, intuitive metric for screening investments and communicating expected annualized returns. But it has important limitations—especially around reinvestment assumptions, scale, and unconventional cash flows. Best practice is to use IRR together with NPV (and MIRR, XIRR, sensitivity analysis) and to apply judgment about strategic and non-financial objectives.
Sources
– Investopedia. “Internal Rate of Return (IRR) Rule.”
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.