LESSON 5 – THE INTERNAL RATE OF RETURN - PROBLEMS

The internal rate of return rule contains several problems that we are going to studied
in this lesson.

1. THE IRR IS NOT EASY TO CALCULATE

As we have studied in the previous lesson the IRR is used to choose among investments,
comparing the rate of return of different projects. To calculate the correct return, or
yield, requires us to find the rate that equates the present value of the future cash flows
to the initial investment. That is, we have to solve:

𝑁𝑃𝑉 = 0 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠

𝐶𝐹 𝐶𝐹 𝐶𝐹
= −𝐼 + + + ⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)

To solve this equation could be quite complicated if it has too many terms, as we will
need to solve an n degree equation. It is easy to do using an Excel sheet, but if you have
to do it by hand, the easiest way to calculate is trial and error and using linear
interpolation to estimate the IRR. Interpolate is to estimate values of a function between
two known values. As we know that the IRR is the rate that makes the NPV equal to zero,
we know that this rate will be between a rate that makes the NPV positive and a rate
that makes the NPV negative. Then, we must find first these two rates by trial and error
and then apply the formula that follows:

𝑁𝑃𝑉
𝐼𝑅𝑅 . = 𝑖 + (𝑖 − 𝑖 ) ×
𝑁𝑃𝑉 − 𝑁𝑃𝑉

Where:

i1  is the rate that makes the NPV positive

i2  is the rate that makes the NPV negative
NPV1  is the positive NPV

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NPV2  is the negative NPV (as this number is a negative number, actually you should
add it, since – is +)

Example  Let us imagine that we have the opportunity to invest in a project with the
following cash flows:

Year Cash Flow (€)

0 -40,000
1 16,000
2 16,000
3 16,000
4 12,000

we want to calculate its IRR and we do not have a computer available. Then, the first
thing we must do is to calculate the NPV of this project with different rates to obtain a
positive NPV and a negative NPV, it is a trial and error problem, but bear in mind that
the higher the rate of return, the lower the value of the NPV. In this case we are going
to calculate with 18% and 20%, and we are going to obtain the following results:

Year Cash Flow (€) PV (18%) PV (20%)

0 -40,000 -40,000 -40,000
1 16,000 13,559 13,333
2 16,000 11,491 11,111
3 16,000 9,738 9,259
4 12,000 6,189 5,787

NPV 978 -509

Now we have enough information to estimate the IRR of this project:

978
𝐼𝑅𝑅 . = 0.18 + (0.20 − 0.18) × = 0.1932 → 19.32%
978 − (−509)

If we calculate the IRR with the Excel sheet, we obtain 19.30%, so the approximation is
pretty good. This is because the rates we have use for interpolation are close to the IRR.

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 2. THE IRR DO NOT ALLOW US TO KNOW IF WE ARE LENDING OR BORROWING

Till now we have considered that the initial investment is always negative and then we
have positive cash flows. It is, we are investing, and the payment comes first. However,
we can be borrowing, or we can have a project in which the funds are received first, and
the payments comes later, which also means funding. For example, consider a company
conducting a seminar where the participants pay in advance, as the expenses are
incurred at the seminar date, cash inflows precede cash outflows. In these cases, the
NPV does not increase as the rate decrease but the opposite thing occurs. Then, we
should choose the project when its IRR is below the cost of capital. This means we are
funding our project at a rate that is better than the one in the market, we are paying
less for borrowing money, and creating more wealth.

Example  Consider the following two projects:

Project A Project B
Year Cash Flow (€) Cash Flow (€)
0 -100 100
1 130 -130

IRR 30% 30%

NPV (10%) 18.18 -18.18

Each project has an IRR of 30%. Does it mean that they are equally attractive? Clearly
not. In the case of A we are “lending” money at 30%. In the case of B we are “borrowing”
money at a 30%. When we lend money, we want a high rate of return; when we borrow
money, we want a low rate of return. That is why the NPV is negative in the case of B. In
project A the NPV is negatively related to the discount rate, while in project B the NPV
is positively related to the discount rate. Obviously, the IRR rule, as stated in the previous
lesson, will not work in this case; we have to look for an IRR less than the opportunity
cost of capital. For this type of project, the following rule applies: Accept the project
when the IRR is less than the cost of capital and reject the project when the IRR is greater
than the cost of capital.

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 3. THE IRR CAN GIVE MULTIPLE RESULTS

When a project has a negative cash flow, a positive cash flow, and another negative cash
flow, we say that the project’s cash flows exhibit two changes of sign. Although this
pattern might look a bit strange at first, many projects require outflows of cash after
some inflows. In this case, the project will have not one but two IRRs. In theory, a cash
flow stream with n changes in sign can have up to n IRRs. There are also cases in which
no IRR exists. In these cases, the best option is to calculate the NPV, but there are a
number of adaptations of the IRR rule for such cases. We are going to study one: The
Modified Internal Rate of Return (MIRR).

The Modified Internal Rate of Return (MIRR)

To calculate the MIRR the first thing we should do is to calculate the present value of
the negative cash flows, discounting them at the opportunity cost of capital. The second
step is to calculate the future value of the positive cash flows at the opportunity cost of
capital or at another rate we consider more appropriate, if we consider that cash flows
will be reinvested in projects with a different risk. After doing this we will have the
negative cash flows in today’s euros and the positive cash flows at the end of the period
of our investment. Then, the third step is to equalize both values obtained earlier and
find the rate that makes that equality possible.

Example  Suppose that we have an investment project with the following cash flows:

Year Cash Flow (€)

0 -100
1 50
2 90
3 -20
4 80
5 -60
6 40
7 30
8 60
9 -180
10 8

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If we calculate the IRR of this project, we will obtain two different results: 0,498% and
28.64% because there are signs changes in the cash flows. Then, we are not going to be
able to take a decision about the investment project using the IRR rule, we will be
confused. To solve this problem, we can calculate the modified IRR. To do so we are
going to calculate the present value of the negative cash flows, considering an
opportunity cost of capital of 10%:

20 60 80
𝑃𝑉 = +100 + + + = 228.62
(1 + 0.10) (1 + 0.10) (1 + 0.10)

Now we have to calculate the future value of the positive cash flows. We are going to
do it considering as a discount rate of 10%, because we consider that we can reinvest
this cash flows at the same rate, but it is possible to use another rate:

𝐹𝑉
= 50 × (1 + 0.10) + 90 × (1 + 0.10) + 80 × (1 + 0.10)
+ 30 × (1 + 0.10) + 60 × (1 + 0.10) + 8 = 631.64

Finally, we have to equalized both results, but considering that they are in different
moments of time:

𝐹𝑉 631.64
𝐹𝑉 = 𝑃𝑉(1 + 𝑀𝐼𝑅𝑅) → 𝑀𝐼𝑅𝑅 = −1= − 1 = 0.1070 → 10.70%
𝑃𝑉 228.62

Now we can say that this investment project is profitable enough because its MIRR is
higher than the cost of capital. If we can choose among different projects, we will choose

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those with higher MIRR. This method fixes some of the problems of the IRR, but still it is
not better than the NPV.

4. THE IRR COULD BE MISLEADING WHEN CHOOSING AMONG MUTUALLY EXCLUSIVE

PROJECTS

Definition of independent and mutually exclusive projects

An independent project is one whose acceptance or rejection is independent of the

acceptance or rejection of other projects. Two mutually exclusive projects, for example
A and B, mean that you can accept A or you can accept B or you can reject both of them,
but you can not accept both of them. For example, A might be a decision to build an
apartment building in a corner lot that you own, and B a decision to build a movie
theatre in the same place. Then you can accept just one of them. In this kind of cases
the IRR gives some problem we are going to study.

The scale problem

Example  Imagine that you have two mutually exclusive projects with the following
cash flows:

Project A Project B
(Small budget) (Large budget)
Year Cash Flow (€) Cash Flow (€)
0 -100,000 -250,000
1 400,000 650,000

IRR 300% 160%

NPV (25%) 220,000.00 270,000.00

Which would you choose? The correct answer is project B, which is the project with the
highest NPV, because if we can choose B is because we have 250,000€ in our pocket and

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if we invest them, we will gain 270,000€, it is, 50,000€ more that if we invest in A. So, If
I choose A we are not earning 50,000 that we can earn. This example illustrates a defect
with the IRR criterion as the basic rule indicates the selection of A because the IRR is
higher, a 300%, while the IRR of B is 160%. The problem here with the IRR is that it
ignores issues of scale. Although project A has a greater IRR, the investment is much
smaller, so the high percentage of return on project A is more than offset by the ability
to earn at least a decent return on a much bigger investment under project B. You can
salvage the IRR in these cases by looking at the IRR on the incremental cash flows.

The internal rate of return of the incremental cash flows – The Fisher Intersection

Example  Now we are going to calculate the IRR of the incremental cash flows of our
previous example. The idea is to find what is better, to take the small project and leave
the rest of our money in the market, in which the money could be invested at the cost
of capital, or to invest on the big project. For that we should calculate the profitability
of the amount of money we do not invest in A invested in B. That percentage is the IRR
of the incremental cash flows. To calculate this number, we should calculate the
different between project A and B and then calculate the IRR of this difference as
follows:

Project A Project B
Project B - Project A
(Small budget) (Large budget)
Year Cash Flow (€) Cash Flow (€) Year Incremental Cash Flow (€)
0 -100,000 -250,000 0 -150,000
1 400,000 650,000 1 250,000

IRR 300% 160% IRR 66.67%

NPV (25%) 220,000 270,000

The IRR on the incremental investment is 66.67%, which is well in excess of the cost of
capital we have consider that was the 25%, the rate we have use to calculate the NPV of
both projects. So, you should prefer project B to project A. However, this always
depends on the cost of capital of the project. In this case is the cost of capital were 70%,
would be better to invest in project A and leave the rest of the money in the market
where we can earn a 70%, it is, a higher profitability that the one we can obtain for that

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money invested in B. If the cost of capital is 66.67%, we will earn the same money in
both cases. Let us see this in a graphic:

500,000

400,000

300,000

200,000
NPV (€)

100,000

0
0

3
0.6

1.2

1.8

2.4
0.12
0.24
0.36
0.48

0.72
0.84
0.96
1.08

1.32
1.44
1.56
1.68

1.92
2.04
2.16
2.28

2.52
2.64
2.76
2.88

3.12
3.24
3.36
3.48
-100,000

-200,000
Discount rate % (Cost of capital)

A B

In this graphic the blue line represents project A and the orange line represents project
B. As you can see, they cross at one point. That point is the Fisher Intersection that
coincides with IRR of the incremental cash flows. Actually, they are the same thing. In
our example the discount rate at this point is 66.67% and the NPV for both projects is
140,000€. As you can see for rates below 66.67% the NPV of B is always higher, that
means that for these rates project B is the best option, the one that maximizes our
wealth. On the contrary, for rates above the 66.67% (to 300%, which is the IRR of A) is
better project A as its NPV would be higher. It is:

− For rates between 0% to 66.67% we choose project B.

− For 66.67% both projects become equally profitable, we can choose any of them.
− For rates between 66.67% to 300% we chose project A.

In conclusion, unless you look at the incremental expenditure, IRR is unreliable in

ranking project of different scale.

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The time problem

Another somewhat similar problem appears when we compare projects that offer
different patterns of cash flows over time.

Example  Suppose a firm can take project C or project D but not both:

Project C Project D
Year Cash Flow (€) Cash Flow (€)
0 -10,000 -10,000
1 10,000 1,000
2 1,000 1,000
3 1,000 1,000
4 0 12,500

NPV (0%) 2,000 5,500

NPV (10%) 669 1,025

NPV (15%) 109 -7,717

IRR 16.04% 13.09%

We find that the NPV of project D is higher for low discount rates and the NPV of project
C is higher with high discount rates. This is nor surprising if we look closely at the cash
flow patterns. The cash flows of C occur early, whereas the cash flows of D occur later.
If we assume a high discount rate, we favor project C because we are implicitly assuming
that the early cash flow (for example, the 10,000€ of year 1) can be reinvested at that
rate. Because most of the project D cash flows occur in year 4, D’s value is relatively high
with low discount rates.

When we have to choose between project C and D, it is easiest to compare the net
present values. But if you want to use the IRR, you can use it as long as you look at the
internal rate of return of the incremental cash flows, exactly as showed above.

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