IRR can be misleading because it assumes intermediate cash flows are reinvested at the same high rate, ignores the absolute size of returns, and is sensitive to timing, often inflating short-term project performance. It can produce multiple, confusing results with irregular cash flows.
Internal Rate of Return (IRR) is widely used in venture capital to measure annualized profitability, but it has critical flaws that can mislead investors. Key limitations include sensitivity to cash flow timing, unrealistic reinvestment assumptions, and its inability to reflect absolute dollar returns.
With mutually exclusive projects, IRR can be misleading. IRR sometimes ignores magnitude of scale of the project. IRR is also unreliable in ranking projects that offer different patterns of cash flows over time.
IRR can sometimes produce multiple values when a project has alternating cash inflows and outflows (negative cash flows, then positive cash flows, then negative), making decision-making confusing. NPV avoids this issue by providing a clear monetary value of the investment's profitability.
IRR works only for investments that have an initial cash outflow (the purchase of the investment) followed by one or more cash inflows. IRR can't be used if the investment generates interim negative cash flows. IRR does not measure the absolute size of the investment or the return.
(8) Can IRR be manipulated? Yes, IRR can be influenced by the timing of cash flows. For example, early large distributions can artificially inflate IRR, even if the subsequent returns are minimal. This is why it's important to consider IRR alongside other metrics like TVPI.
Erroneously imposed on NPV and IRR, this fallacy suggests that already-distributed cash flows must be reinvested at an assumed rate. This is logically flawed: once cash flows incorporate the firm's reinvestment and payout policies, no further assumptions are needed. Adding them implies distorting true profitability.
Limitations of IRR
In the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values. Moreover, if all cash flows have the same sign (i.e., the project never turns a profit), then no discount rate will produce a zero NPV.
So the rule of thumb is that, for “double your money” scenarios, you take 100%, divide by the # of years, and then estimate the IRR as about 75-80% of that value. For example, if you double your money in 3 years, 100% / 3 = 33%. 75% of 33% is about 25%, which is the approximate IRR in this case.
One quick way of checking that the calculated IRR is correct for a project is to insert the IRR % value answer as the minimum return % that is used to calculate the NPV.
One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.
Things to remember about the IRR Function
error – Occurs when: If the given value array does not contain at least one negative and one positive value. The calculation fails to converge after 20 iterations. If the internal rate of return is unable to find a result that works after 20 tries, then the #NUM!
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IRR is unreliable in two cases: when comparing mutually exclusive projects and when a project has positive cash flow followed by a negative cash flow.
However, IRR has some disadvantages that make it inadequate. It does not factor in size, length of execution, or susceptibility to external danger. It also assumes that reinvestment occurs at IRR, which is often unacceptable. All these factors continue to create problems for investment analysis with IRR.
The Problem: If Excel has to go through more than 20 iterations to find the IRR, it will come up with #NUM! error value. The IRR function expects at least one positive cash flow and one negative cash flow; otherwise, it returns the #NUM!
Illustrating the Problems of Solely Depending on the IRR
Upon examining the table, it becomes clear that the IRR alone will tell us nothing about actual periodic payments or total profitability. There can be an almost infinite variability in cash flow streams and total profit that will equal a 12% IRR.
Disadvantages of IRR
Unlike net present value, the internal rate of return doesn't give you the return on the initial investment in terms of real dollars. For example, knowing an IRR of 30% alone doesn't tell you if it's 30% of $10,000 or 30% of $1,000,000.
Limitations of Average Return
It does not account for different projects that might require different capital outlays. In the same vein, it ignores future costs that may affect profit; rather, it only focuses on projected cash flows resulting from a capital injection.
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