How do you deal with multiple IRRs or no IRR scenarios?

The internal Rate of Return is the minimum level of return that the investment needs to deliver, to be worthwhile. Assuming the cost of capital of the project/division/business is known, IRR can be an intuitive approach and help facilitate go (i.e., IRR > WACC) or no-go (i.e., IRR < WACC) investment discussions effectively.

The Internal Rate of Return (IRR) is the discount rate that makes the Net Present Value (NPV) of a series of cash flows equal to zero. It reflects the annualized return of a project or investment, assuming reinvestment at the same rate. IRR is valuable in cash flow management because it allows comparison across projects with varying sizes, durations, and risk levels. Additionally, it helps determine if a project meets a minimum required return or hurdle rate.

The key limitation with the IRR calculation is that it assumes reinvestment of any repayments at the same rate - leading to overestimating returns especially for amortising loans and short-duration projects. Something to bear in mind when seeing unrealistically high IRRs for certain projects.

Besides the multiple sign changes (i.e., in- or out-) in the cash flows, there could also be various WACC's from different streams of cash flows at play. This makes it difficult to resort to one single IRR to make investment decisions. Also, the assumption underlying the IRR method is that WACC is a known fact to derive at the PV, which is not always the case.

Shouldn't it be the maximum cost the entity is ready to bear? I wonder on something: I think the minimum return should be the cost of capital. Suggestions? JuanLiu on number 1.

IRR can be tricky when CFs are irregular/ change signs often. Analyzing such cases needs a thorough grasping of the project dynamics. For e.g: Assume u’re assessing an invt. proj with the foll CFs: Initial outflow (Yr 0): -$10K Inflows (Yr 1): $3k Inflows (Yr 2): $4k Outflow (Yr 3): -$2K Inflows (Yr 4): $5k To reach IRR, we solve for the disc rate that makes d NPV = zero: NPV=CF0/(1+r)+CF1/(1+r)1+CF2/(1+r)2+CF3/(1+r)3+CF4/(1+r)4=0 Using trial & error/specialized SW, we find there are 2 potential IRRs: approx. 12.5% & 25.5%. The CF changes signs twice(from outflow to inflow & back to outflow), leading to multiple solns. Or if d initial outflow was bigger(-$15K), there might be no real soln for IRR & proj doesn’t meet d reqd return.

When there are multiple IRRs in the cash flow, there can be trade-offs (over- or under-valued profitability) when just choosing one of them. Referring back to the NPV method, where a positive net present value (derived from cashflows at the cost of capital), is still the leading principle in investment selection.

There are some projects that will have no IRR. Those may be for safety concerns that are just unavoidable. Corporate directives may require an IRR calculation be performed for projects over a certain dollar value. For example, many years ago at a former employer, we purchased several AEDs to have strategically located within our facility. There are no cash inflows for that type of purchase. However, making a call to a relative and telling them that their loved one under our employment wouldn't be coming home that day because we didn't see the positive return on the investment in AEDs would likely prove in the courts to be a much more costly outlay to the employer.

No IRR means for the given foreseen period, there would never be enough cash inflows (or outflows) to catch up with the cash outflows (or inflows). Although the hard financial calculation does not seem to uphold such an investment initiative, I would challenge or play around with the assumptions used here, such as extending the investment period a bit beyond the current horizon--especially those strategic projects, their return can take rather a long time to materialize and the time factor needs to be considered. Or ask if all the benefits are captured, e.g., beyond immediate financial return, such as employee turnover, ESG-related risk reduction etc. And indeed, you can always fall back on the NPV as the golden rule if nothing matches up.

When you encounter a situation where there is no Internal Rate of Return (IRR), it’s essential to use other criteria to evaluate the project or investment. One effective method is to use the Net Present Value (NPV). NPV measures the absolute value added by a project or investment and is positive when the return exceeds the discount rate. This method provides a unique and consistent answer, regardless of the cash flow pattern. Another approach is to use the Payback Period, which calculates the time required to recover the initial investment from the cash inflows. While it doesn’t account for the time value of money, it gives a quick estimate of the investment’s liquidity risk.

IRR is limited in that it may be tough to reach a conclusion when there are multiple IRRs due to non conventional cash flows. Also, the change of discount rates may make IRR lie between the different rates thus making it impossible to decide at glance. In addition, the commonly used linear interpolation method is somewhat erratic as it presumes a linear relationship between NPV and discount rates. Die to possible wrong ranking of investment projects, IRR may be replaced by NPV, which overcomes most of its shortcomings. The profitability index method mentioned actually incorporates NPV, albeit sometimes indirectly, but it is merely useful during capital rationing of divisible projects.

It might also be worth deploying models like Baumol model and Miller orr model. Additionally, better management of working capital would improve cash position.

Improving your Cash Flow mgmt skills is key for business success. Practical steps u can take: Learn about IRR, NPV & MIRR. These tools aid evaluate investment opportunities & assess cash flows over time. Grasp how these metrics impact decision-making & profitability. Practice using IRR, NPV & MIRR in real-world situations. For instance: Calculate the IRR for a project with multiple cash inflows & outflows. Assess NPV for an investment, factoring in time value of money. Address scenarios where there’s no IRR (e.g., mutually exclusive projects). Explore learning resources like Courses, books, Podcasts, Blog & Mentors. Practice CF Forecasting. Anticipate inflows & outflows. Monitor cash flow & adjust strategies based on actual performance.