In Which Scenarios Would IRR Always Recommend the Wrong Decision?

The internal rate of return (IRR) is a widely used metric for evaluating investments, but it has limitations that can lead to poor decisions. While IRR provides a percentage-based measure of profitability, certain scenarios make it unreliable or misleading. Investors who rely solely on IRR may select suboptimal projects.

Understanding when IRR fails helps investors avoid costly mistakes. Some situations create multiple IRRs, distort project comparisons, or misrepresent reinvestment assumptions. Recognizing these pitfalls leads to better financial decisions.

Multiple IRRs in Complex Proposals

When a project’s cash flows alternate between positive and negative more than once, multiple IRRs can result. This happens because IRR is the discount rate that sets the net present value (NPV) of cash flows to zero. If cash flows fluctuate significantly, the IRR equation may yield more than one valid solution, creating ambiguity.

For example, a project that requires an initial investment, generates positive cash flows for several years, but later demands a significant reinvestment before producing additional returns can produce multiple IRRs. Industries with large capital expenditures followed by reinvestment cycles, such as infrastructure development or energy, frequently encounter this issue.

To address this, financial analysts often use the modified internal rate of return (MIRR), which accounts for reinvestment assumptions and provides a single, more reliable figure. Alternatively, relying on NPV avoids the confusion caused by multiple IRRs, as it provides a clear dollar-value measure of a project’s contribution to wealth.

Substantial Reinvestments at Later Stages

Projects requiring significant reinvestment well after the initial investment can make IRR misleading. The IRR calculation assumes that all interim cash flows are reinvested at the same rate as the IRR itself, a scenario that is rarely realistic. If actual reinvestment opportunities yield lower returns, the project’s true profitability is overstated.

Consider a long-term infrastructure project that generates positive cash flows in the early years but requires a major reinvestment midway for expansion or modernization. If market interest rates are lower than the project’s IRR, reinvesting at the assumed rate may not be possible. This issue is particularly relevant in industries with phased investments, such as commercial real estate developments or pharmaceutical R&D.

For instance, a property developer might generate rental income early on but need a large capital injection later for renovations or additional construction. If the reinvestment cannot achieve the same return as the initial project, relying on IRR alone can make the project appear more attractive than it truly is.

Distorted Comparisons of Project Scale

Comparing projects of different sizes using IRR can lead to flawed conclusions. IRR expresses returns as a percentage, which can be misleading when one project requires significantly more capital than another. A smaller project with a high IRR might seem superior, but the absolute dollar gains from a larger project with a slightly lower IRR could be far greater.

For example, consider two investment options: Project A requires $100,000 and generates a 40% IRR, while Project B demands $1 million but yields a 25% IRR. If decision-makers rely solely on IRR, they might choose Project A, believing it to be the better option. However, in absolute terms, Project B produces substantially greater total profit. A 25% return on $1 million results in far more wealth creation than a 40% return on $100,000.

This issue becomes even more pronounced when companies face capital constraints. If a firm has access to substantial funding, prioritizing the highest IRR could mean passing on larger, more lucrative projects. Capital-intensive industries like manufacturing or energy often encounter this dilemma. A power plant expansion may have a lower IRR than a small-scale renewable energy project, but its overall contribution to profitability could be much higher.

Projects With Dramatically Different Durations

Comparing projects with vastly different time horizons is another challenge. IRR does not account for the length of time a project takes to generate returns, which can lead to misleading conclusions. A short-term project with a high IRR may appear more attractive than a long-term initiative with a lower IRR, even if the latter produces significantly greater value over time.

For example, an investor choosing between a two-year project with a 30% IRR and a ten-year project with a 15% IRR might favor the shorter project due to its higher percentage return. However, once the short-term project concludes, the investor must find a new opportunity to reinvest the proceeds. If subsequent investments do not achieve the same high return, the long-term project might have been the better choice.

This issue is particularly relevant in industries with extended project lifecycles, such as mining, telecommunications infrastructure, or commercial aviation, where long-term investments often yield substantial cumulative profits despite lower annualized returns.