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This 2004 McKinsey Quarterly article reports that, back in 1999,

three-quarters of CFOs always or almost always use[d] IRR when evaluating capital projects.

The same article warns against the pitfalls of the internal rate of return (IRR). Although using the latter makes sense if the project only consists of an initial investment and a final cash inflow, things start to get hairy when the project includes interim cash flows:

  • The definition of the IRR is not mathematically sound because, for such projects, there can be multiple IRR values. Some people say that, in that case, you should pick the smallest of those values (rationale?). However, Excel's IRR routine does not unconditionally converge to that smallest value, as it uses some rootfinding method that requires an initial guess, which influences the result returned.
  • An underlying assumption of the IRR is that interim cash flows can and will be reinvested at the same rate as the IRR, which is rarely the case. This rather strong assumption introduces distortion that can

make bad projects look better and good ones look great.

For those reasons, the article recommends staying away from the IRR as much as possible and preferring other metrics such as the Net Present Value (NPV) and the Modified Internal Rate of Return (MIRR).

I don't work in the world of finance (I've got an engineering background), but the few finance guys who I rub shoulders with use the IRR seemingly without being aware of its limitations. Hence my questions (all related, really):

  • Has the article's message sunk in since 2004?
  • Or do (industry) people still routinely use IRR for capital budgeting?
  • Do you know of more recent reports on the popularity (or lack thereof) of the IRR?
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Without knowing for sure I would reckon that IRR is still used in one form or the other because in the end IRR really just measures some kind of "hurdle rate" and the question becomes is this a return that overcomes the cost of funding, the required return, a competing return. In the end that is what most everyone is concerned about whether it be personal finance, trading, funding, capital budgeting. But it is just a hunch and definitely does not qualify as answer so maybe someone with direct knowledge can add more value... –  Matt Wolf Aug 9 '13 at 2:38
    
@MattWolf Thanks Matt, but I don't think you're supposed to derive a hurdle rate from the IRR. My understanding is that people would compute the IRR and then compare it to their hurdle rate to determine whether a project should be undertaken or not. See this. –  Jubobs Aug 9 '13 at 10:29
    
I used hurdle rate in a very loose manner, sorry for the confusion. If there are otherwise no other required rates then an example of "hurdle rate" would be 0%, meaning, the project is expected to be net profitable. But then as mentioned I have ever worked in corporate finance and so please excuse my incorrect usage of terminology. –  Matt Wolf Aug 9 '13 at 10:47
    
@MattWolf That's quite alright :) I'm more of a noob than you are. –  Jubobs Aug 9 '13 at 10:48
    
@MattWolf I'm not getting a more definitive answer. Do you think my question belongs on another SE site? –  Jubobs Aug 13 '13 at 7:48

3 Answers 3

up vote 2 down vote accepted
+100

Disclaimer before I add my take: I am not a corporate finance practitioner and do not work on budgeting decisions at a large corporation. Rather, I make budgeting decisions for the quant fund I manage. As thus my points may not reflect the point of view of a corporate finance practitioner but nonetheless I believe my points are equally applicable and having had numerous conversations with corporate treasurers of banks but also non financial corporations I believe I have an idea about the thought process going on inside someone who makes budgeting decisions.

I like to present a theoretical view and then the practitioner's view:

Theory:

  • I do not want to go into the details of pitfalls of IRR or NPV but overall the advantage of using IRR is that it produces a single number, it leads to results without making too many assumptions. However, IRR suffers from deficiencies in regards to intermittent cash flows. Also, IRR can result in multiple solutions.
  • On the other hand NPV may require more assumptions. Especially tricky is which rate to chose to discount each of the cash flows. However, in its complexity lies also its accuracy: NPV allows you to discount cash flows at different discount rates. In corporate finance the discount rate can be interpreted in various ways. Some of such interpretations are "hurdle rate", weighted cost of capital, risk adjusted cost of capital, or financing cost. They are not one and the same and thus assumptions have to be made which exact discount rate to chose. However, despite lots of literature claiming NPV to be complicated I find the theoretical construct very logical because it results in a present value of future cash flows which is what anyone interested in such computations should ultimately be interested in.

Here couple links that describe the comparison between IRR and NPV more in detail:

INTRODUCTION TO CAPITAL BUDGETING

Time Value of Money and Investment Analysis

Capital Budgeting & Project Appraisal

Comparing Net Present Value and Internal Rate of Return

This is as far as theory is concerned.

Practical Application:

  • As IRR involves an easier calculation it is the preferred method of use. Management likes simple numbers even if the assumptions are faulty but within the ballpark. IRR has traditionally been used so most practitioners prefer not to shake up things and rather stick to the status quo. Nobody wants to be challenged to answer why they chose different discount rates for each future cash flow and how they arrived at each of those rates. The truth is that any such rates and future cash flows are inherently assumptions that involve a margin for error. When upper management makes decisions they want to be told by their subordinates whether a project produces an IRR that is higher than their overall financing cost for that overall group, region, brand,...most of those guys do not like to hear that a large degree of guess work was at play.
  • NPV is by far the more logical way to arrive at a project's expected return. Not only can any type of intermittent cash flows be embedded but each cash flow can be discounted at a different rate, and it should be that way! If a project produces different types of future cash flows (for example, news paper subscriptions: Positive future subscription revenues embed a different type of risk for long-term subscribers vs the subscription revenue earned from new subscribers, hence the future cash flows originating from such subscriptions should be discounted at different rates.). NPV produces far more accurate results despite its multiple assumptions because it reflects a more realistic treatment of future cash flows. Another example are budgeting costs for a trading business of one specific desk. A trading desk may trade in different asset classes, each asset class being of different risk grade. Thus, the financing cost are different. While a bank or hedge funds itself externally on just one or very few rates (realistically not just one rate) internally financing rates are entirely different: An equity trading desk will be charged very different financing rates than a commodities or bond trading desk because they all produce future cash flows of different risk grades. Even one single desk has different traders, some taking wild swings but larger expected cash flows while others are more risk averse and steadily but more slowly build pnl. That should in theory all be considered. Of course that is not the case because a trade-off has to be made between efficiency and accuracy. But I think it is a good reflection of what really goes on within managers involved in capital budgeting.

  • However, I like to highlight another aspect which is the political component: Sometimes capital budgeters are forced to arrive at a specific number so they basically need to tweak inputs to arrive at the desired outcome rather than the other way around. Managers' motivations are rarely perfectly aligned with long-term business growth, not even with shareholder or stake holder interests. If one's bonus depends on how many new projects have been proposed and approved by upper management then it tremendously helps to present "juicy propositions" that may not rely on realistic numbers to push the project to the approval stage. Especially for long-term projects most managers care very little what happens 5 years down the road if they look to cash in big time on their next 3 years' worth of bonuses. Sadly, especially in financial operations this is rather the norm than the exception and this I think is born out of the fact that labor mobility is very high between financial corporations. Also financial practitioners generally have a very short-term memory. If one fails, he/she can take some time off or maintain a low profile only to knock on the next door several months or a year down the road and still get a very fair shot. That also happens in normal corporations but I would guess at a much lower rate. One reason for that could be that CEOs of normal corporations are more credited but also held more accountable for the success/failure of the business while financial corporation's CEOs generally get away with bad performance as they can blame market conditions for such challenges. The world is what it is and as long as especially the current American business model with extreme short-term focus on quarterly results, dividend payments, bonuses, the ridiculous amount of short-term staff evaluations (lots of research has shown that it greatly diminishes staff morale and efficiency to evaluate and monitor each other on an almost constant basis and that the cost of such constant evaluations are higher than the perceived benefits) prevails, things most likely won't change much. As long as shareholders and consumers maintain a short term focus, so will corporations and its management.

Summary, in theory IRR suffers from simplistic assumptions and but it is easier to come up with a single number while NPV is far more accurate but involves more assumptions and is more complex to structure. Practitioners need to balance efficiency vs accuracy, however, keep in mind that there are also political undercurrents involved in the choice of technique. Not everything in business comes down to simple number crunching.

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I worked at two large industrial companies for several years and I saw how they evaluate investment projects. The thing is that investment people use any measure that looks good to approve the project they want to be approved. If IRR looks good, they show you IRR. If IRR is bad, they use something else, f.e. NPV. And NPV is extremely nice when comparing two projects of different term, for example.

I wanted also to add that there can't be any "industry standard" for investment projects. Everyone calculates IRR, but the way it is used depends on project type.

And I can't understand how the hell is this question related to quant finance ))

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Thanks for your answer. Unfortunately, I can't give you an upvote, because of my low rep. I understand the question may be only peripheral to quantitative finance, but it deals with a metric used in finance, so I just went for it. The community is entitled to close or migrate it, if appropriate, but there doesn't seem to be any SE website for which this question is more suitable (see Matt's comment above). –  Jubobs Aug 13 '13 at 10:39
    
The attitude displayed by the investors you describe seems kind of schizophrenic: in the investors' own interests, shouldn't there be a perfect overlap between the "projects they want to be approved" and the ones that all (sound) metrics describe as attractive? –  Jubobs Aug 13 '13 at 10:41
    
I don't know how to answer. Simple answer would be: Yes, it should, but not always happens. Then, if we do not account for any possible corruption (which is of course impossible!), even in this case I am sure that no metric can be a good forecast of possible project outcome. None of them (IRR, NPV) accounts for risks well. –  Rustam Aug 13 '13 at 11:30
    
Some Monte-Carlo simulation of the project might look more helpful. But such models are highly susceptible to model risk (i.e. such models use unrealistic assumptions and thus might be even more deceptive) –  Rustam Aug 13 '13 at 11:33
    
And that is why managerial experience (in case their decisions are not biased by their personal interest) might be more sound than any of these stupid metrics –  Rustam Aug 13 '13 at 11:34

In my opinion the internal rate of return should be used in the discounting factor which enters the NPV calculation, weighted by some credit risk factor, or having added a credit risk spread. Unless you discount by the targeted rate of return, as for the hedge funds. But I have the strong feeling that NPV is calculated by discounting with the risk-free interest rate. Hence IRR is not as popular as it should be.

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1  
No offense, but this makes no sense to me at all. –  Jubobs Aug 14 '13 at 22:13
    
If you use the IRR as a discount factor for NPV calculation, your NPV will be 0. –  nsw Jul 31 at 0:40
    
F=final, I=initial, IRR=(F-I)/I; NPV=F/(1+IRR)=F/(I+F-I)/I=I. The present balue of the final cashflow F is the investit cash I. ? –  user7056 Aug 2 at 14:27

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