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.
When the calculated IRR is higher than the true reinvestment rate for
interim cash flows, the measure will overestimate — sometimes very
significantly — the annual equivalent return from the project. The formula
assumes that the company has additional projects, with equally attractive
prospects, in which to invest the interim cash flows. In this case, the
calculation implicitly takes credit for these additional projects.
Calculations of net present value (NPV), by contrast, generally assume
only that a company can earn its cost of capital on interim cash flows,
leaving any future incremental project value with those future
projects.
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