Weaknesses of Internal Rate of Return (IRR)

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Weaknesses of Internal Rate of Return (IRR)
The primary weaknesses of this method are:
- IIR sometimes requires unrealistic assumptions about reinvestment of funds, and
- Manual calculation is difficult.

Weaknesses of IRR Method
Alpin McGregor, Member
The easiest way of looking at weakness of IRR model is by comparing 2 situations:
1. You have $1 and earn 100% rate of return in one year. You will have $2 at the end of the year.
2. You have $100 and earn 10% rate of return in one year. You will have $110 at the end of the year.
If you base your decision on Internal Rate of Return you will always prefer situation 1.
If you base your decision on NPV you will always prefer situation 2.
The problem in real life situations is that if you could find 100 projects of $1 that will give you 100% return then clearly that is better than one project of 100 at 10% rate of return.

Evaluation Methods are All Based on Assumptions
Rachid LANGAR, Member
Project evaluation are mostly based on assumptions and don't require to be very accurate.
None of the evaluation methods (IRR / NPV) is perfect when used alone for evaluation - each one has its own weaknesses - but when they are used jointly & professionally, they will lead to reliable/realistic results. Especially when they are backed-up with the appropriate sensitivity analysis.
The aim is to increase the level of confidence in your project evaluation as much as possible.

Do not Use IRR When Investing in Business Improvements
Tyrone Skogstrom, Member
I do not recommend IRR as a decision factor for example IT investments or any investment with business improvement as objective. IRR works well only if you have one single initial year of investment (yr 0), followed by only positive yearly cash flows.
Moreover IRR also assumes each positive yearly cash flow can be reinvested with the same discount as you total IRR will be. These two issues can rarely be accomplished. Many IT investments have non-symmetric cashflows, such as for example when you're outsourcing.
because of above issues IRR will then return a wrong result.
Therefore, many organizations do not use IRR for investments in business change projects. However, IRR sometimes is demanded, your organization might define a minimum allowed IRR. A hurdle rate. And you need the data to pass through that hurdle rate.


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