The dangers of using IRR

Value creation is most important when it impacts a lot of people and when it lasts a long time. And IRR has a bias for small, low-impact and short-term projects.

 IRR has a short-term bias

Be careful when using IRR. Do not compare IRR of one project with another project because they are internal rates.

All value is relative.
Instead of comparing IRR percentages to each other, compare the IRR percentages to a benchmark - the cost of capital outside.

IRR calculations favors projects with earlier cash flows - IRR has a short-term bias.
IRR is myopic in that it favours shorter term returns.

Be wary when IRR is used as the decision-making criteria - it indicates a myopic point of view.

Example Calculation

Consider Projects A and Project B:

• Project A Cash flows: [ -2000, 400, 2400 ]  -  IRR = 20%
• Project B Cash flows: [ -2000, 2000, 625 ]  -  IRR = 25%

Try computing the NPV of the two projects for discount rate of 5%, 11% and 20%.
Also, try drawing the graph of NPV vs r for the two projects.

IRR has a small-investment bias

Consider Project A and Project B:

• Project A Cash flows: [ -5000, 7500 ]  -  IRR = 50%
• Project B Cash flows: [ -50,000, 62500 ]  -  IRR = 25%