• Strategy
  • McKinsey & Co.

Internal Rate of Return: A Cautionary Tale

Tempted by a project with high internal rates of return? Better check those interim cash flows again.

Maybe finance managers just enjoy living on the edge. What else would explain their weakness for using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects. (John Robert Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.)

Our own research underlined this proclivity to risky behavior. In an informal survey of 30 executives at corporations, hedge funds, and venture capital firms, we found only 6 who were fully aware of IRR’s most critical deficiencies. Our next surprise came when we reanalyzed some two dozen actual investments that one company made on the basis of attractive internal rates of return. If the IRR calculated to justify these investment decisions had been corrected for the measure’s natural flaws, management’s prioritization of its projects, as well as its view of their overall attractiveness, would have changed considerably.

So why do finance pros continue to do what they know they shouldn’t? IRR does have its allure, offering what seems to be a straightforward comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances.

Admittedly, some of the measure’s deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations — and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards. (As a result of an arcane mathematical problem, IRR can generate two very different values for the same project when future cash flows switch from negative to positive (or positive to negative). Also, since IRR is expressed as a percentage, it can make small projects appear more attractive than large ones, even though large projects with lower IRRs can be more attractive on an NPV basis than smaller projects with higher IRRs.)

We believe that managers must either avoid using IRR entirely or at least make adjustments for the measure’s most dangerous assumption: that interim cash flows will be reinvested at the same high rates of return.

The Trouble with IRR

Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project’s annual return on investment only when the project generates no interim cash flows — or when those interim cash flows really can be invested at the actual IRR.

Discuss

Your email address will not be published. Required fields are marked *