Internal Rate of Return: A Cautionary Tale

When the cost of capital is used, a project's true annual equivalent yield can fall significantly — again, especially so with projects that posted high initial IRRs. Of course, when executives review projects with IRRs that are close to a company's cost of capital, the IRR is less distorted by the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10 percent or more above their company's cost of capital, these may well be significantly distorted. Ironically, unadjusted IRRs are particularly treacherous because the reinvestment-rate distortion is most egregious precisely when managers tend to think their projects are most attractive. And since this amplification is not felt evenly across all projects, managers can't simply correct for it by adjusting every IRR by a standard amount. (The amplification effect grows as a project's fundamental health improves, as measured by NPV, and it varies depending on the unique timing of a project's cash flows.)

How large is the potential impact of a flawed reinvestment-rate assumption? Managers at one large industrial company approved 23 major capital projects over five years on the basis of IRRs that averaged 77 percent. Recently, however, when we conducted an analysis with the reinvestment rate adjusted to the company's cost of capital, the true average return fell to just 16 percent. The order of the most attractive projects also changed considerably. The top-ranked project based on IRR dropped to the tenth-most-attractive project. Most striking, the company's highest-rated projects — showing IRRs of 800, 150, and 130 percent — dropped to just 15, 23, and 22 percent, respectively, once a realistic reinvestment rate was considered. Unfortunately, these investment decisions had already been made. Of course, IRRs this extreme are somewhat unusual. Yet even if a project's IRR drops from 25 percent to 15 percent, the impact is considerable.

What to Do?
The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to be replaced easily. Executives should at the very least use a modified internal rate of return. While not perfect, MIRR at least allows users to set more realistic interim reinvestment rates and therefore to calculate a true annual equivalent yield. Even then, we recommend that all executives who review projects claiming an attractive IRR should ask the following two questions.

1. What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong. Particularly when sponsors sell their projects as "unique" or "the opportunity of a lifetime," another opportunity of similar attractiveness probably does not exist; thus interim flows won't be reinvested at sufficiently high rates. For this reason, the best assumption — and one used by a proper discounted cash-flow analysis — is that interim flows can be reinvested at the company's cost of capital.

2. Are interim cash flows biased toward the start or the end of the project? Unless the interim reinvestment rate is correct (in other words, a true reinvestment rate rather than the calculated IRR), the IRR distortion will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates. (Interestingly, given two projects with identical IRRs, a project with a single "bullet" cash flow at the end of the investment period would be preferable to a project with interim cash flows. The reason: a lack of interim cash flows completely immunizes a project from the reinvestment-rate risk.)

Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions.

The authors, John C. Kelleher and Justin J. MacCormack, are consultants in McKinsey's Toronto office. They wish to thank Rob McNish for his assistance in developing this article.

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