The Sins of the IRR
Using the IRR is common. Unfortunately, its misuse is also common. Although net present value is a more stable metric, the IRR is favored, despite its shortcomings. Investors should know all the drawbacks of the IRR and when using it is inappropriate. The Seven Deadly Sins of the IRR are:
- It assumes all intertemporal cash flows are reinvested at its own rate, usually higher than is possible.
- There are situations in which its iterative calculation process fails to produce a solution.
- When the algebraic sign of the cash flow changes in the middle of the series it is possible to obtain two "right" answers.
- When mutually exclusive projects are considered it can recommend the wrong investment.
- It fails to consider scale, which can lead the investor to invest inefficiently.
- It ignores the difference between risk pooling and risk sharing.
- Simulation of the IRR produces a bias that increases with the variance in the cash flows. Thus, simulation is least accurate when needed the most.
The graphic above illustrates item #7 where the red dotted line ("line") represents the linear simulated IRR and the green line represents the IRR function. The curved line at the bottom tracks the difference, an unavoidable bias, showing its apex at Cash Flow = 150.
You may download an Excel worksheet here that demonstrates this problem