Internal Rate of Return!.......
Colin Thompson
Managing Partner Cavendish/Author/International Speaker/Mentor/Partner
Internal Rate of Return!
A Case of the Emperor's New Clothes?
Most business professionals outside of finance are quick to admit they do not really understand the meaning or use of internal rate of return (IRR). Nevertheless, many are required, by their CFOs or other financial specialists, to deliver IRRs to support funding requests, business case results, or proposals for projects, acquisitions, or other actions.
It is surprising, however, that many of the same financial specialists who require IRRs with incoming proposals are themselves at a loss when they are called on to explain the meaning of IRR figures, or to explain in practical terms how IRR compares to other financial metrics such as net present value (NPV) or return on investment (ROI). Regarding IRR, almost everyone knows that a larger IRR is preferred over a smaller IRR, but beyond that, for many, the meaning of the IRR percentage is a mystery.
A recent Duke University study, for instance, found that 75% of CFOs always or almost always use IRR to evaluate capital spending proposals. Yet this study found that only about 20% of these financial specialists fully understand IRR's most serious deficiencies, or how to interpret—usefully—the meaning of, say, a 30% IRR. Business people in our business case seminars bring the same message: their management considers IRR when deciding the fate of their proposals, but these professionals have never been told why.
When asked for the meaning of IRR, unfortunately, financial specialists and senior managers tend to define IRR instead of explaining it. Or they simply repeat the widely-held belief that IRR is a useful because it "shows directly how returns from a proposed action compare to inflation, current interest rates, and to financial investment alternatives." This last statement is arguably true, sometimes, but it provides no guidance on how to make these comparisons.
As a result, most of our business case seminars include a serious discussion on the use and misuse of IRR. These discussions, by the way, usually end by recommending another financial metric, the modified internal rate of return (MIRR), a more easily interpreted alternative to the familiar IRR.
Two Definitions and the Temptation to Overstate Return Rates
IRR is more easily defined and explained with an example. Consider two proposed investments computing for funding: Case A and Case B. The expected net cash flow streams for A and B are shown in the image Both cases have an initial cash outflow of $220. Case A ends 7 years later with a net gain of $200 while case B ends with a net gain of $240. Which is the better investment? If the company can make only one investment now, which one should it be?
Before addressing the questions with IRR results, note the profiles of the two cash flow streams. Case A has large early returns but these decrease year by year. This profile could be an investment in an income producing asset that becomes more costly to maintain each year. Case B has smaller returns at first, but B's returns grow each year. B's profile could show the results of a product launch that returns greater profits each year. The analyst will thus compare two different kinds of investments with the same metric, IRR.
The net cash flow figures, when analyzed with a spreadsheet function or another IRR program, show an IRR of 30.6% for Case A and an IRR of 20.8% for Case B. But what do those figures mean?
The best known IRR definition explains this comparison in terms that call for a basic understanding of discounted cash flow terms present value, net present value (NPV), and the role of the discount rate in determining NPV:
IRR Definition 1: The internal rate of return (IRR) for a cash flow stream is the interest rate (discount rate) that produces a net present value of 0 for the cash flow stream.
That definition, however, can be less than satisfying when first heard. Many ask: "What does that tell me about returns and costs?" A second IRR definition comes closer to providing some guidance for interpretation.
IRR Definition 2: This definition assumes that investment costs will be financed at a certain annual rate, and that incoming returns will be reinvested at a certain annual rate. IRR is defined as the single rate that equates total investment costs (including financing) with total investment gains including interest earnings from reinvestment.
The second-definition example above should begin to suggest a reason that financial people look to IRR and trust it as an important decision criterion: IRR has built into it the presumption that investment costs (opportunity costs or borrowing) are financed at a cost, and that incoming returns are reinvested, earning additional gains. This view provides meaning for another IRR interpretation, namely that the analyst will compare the IRR rate to actual financing rates and actual reinvestment rates. This comparison, however, has to be interpreted carefully. It is easy to over interpret or misinterpret IRR at this point.
When a proposed investment produces IRR's like those shown above—30.6% for example—many are tempted to reason as follows:
"For this investment, we will not actually borrow at the IRR rate. Our real financing cost will be lower, at a rate closer to our cost of capital, probably less than 10%. Therefore [the reasoning goes], the investment is a net gain because financing rates will really be under 10%, while returns represent earnings at a much higher rate, something like 30.6%."
This reasoning may or may not be supportable. It is most supportable when the IRR is close to the real cost of capital and real investment rate. It is not fully supportable when IRR greatly exceeds those rates. IRR in such cases overstates the real rate of return. When comparing competing mutually exclusive investments competing for funds, moreover, the overstatement can be much greater for one investment compared to the other when the two cash flow streams have different profiles. For this reason, IRR is usually not recommended for such comparisons.
In brief, it is reasonable to conclude that an investment is a net gain when its IRR exceeds the investor's cost of capital. It is also reasonable, usually, to view the investment with the higher IRR is the greater gain. However, the magnitude of the real gain depends on the real cost of capital and the real reinvestment rate, as well as the timing of individual net cash flow events factors that are not visible in the IRR results.
Modified Internal Rate of Return: Clear and Easily Understood Meaning
IRR magnitudes are difficult to interpret, as shown, because IRR can differ from the actual financing and reinvestment rates. It is natural to ask, therefore, "Why not calculate an internal return metric that does reflect the real financing cost rate and real reinvestment rate?" In fact, this solution is readily available as the modified internal rate of return (MIRR) metric. Input data for MIRR includes the same net cash flow figures as IRR, but the MIRR also requires as input a financing rate and a reinvestment rate. Here for comparison are the IRR and MIRR results for example investments A and B from above. MIRR here is based on a reinvestment rate of 8% and a financing rate of 6%:
Investment A: IRRA= 30.6% and MIRRA = 15.1%
Investment B: IRRB= 20.8% and MIRRB = 14.7%
Here, at last is an investment metric with a clear and easily understood meaning! MIRR rates show investment value growing the same way that compound interest earnings build value. The MIRR message for investment A is this: Making investment A brings the same results as putting the investment costs in the bank for 7 years and earning interest at a 15.1% annual rate (assuming the given financing and reinvestment rates are applied). Investment A still shows a greater return rate (MIRR rate) than B, but A's MIRR advantage is very small, compared to the IRR differences between investments .
MIRR rates have a meaning that is understandable and explainable by anyone who understands the basics of interest compounding.
To Use IRR or Not To Use IRR
"The most straightforward way to avoid problems with IRR is to avoid it altogether."
— J. Kelleher and J. MacCormack, McKinsey & Co., in CFO, 2007
Some kinds of investments are well suited for IRR analysis. The cash flow streams from interest-paying bonds, for instance, fits well the assumptions underlying the IRR definitions. Going by the name yield to maturity, IRR in fact plays a central and useful role in bond investment analysis. YTM/IRR results are readily interpreted because the cash flow stream has the profile that IRR expects early cash outflows followed by cash inflows. However, when IRR is routinely applied to other kinds of investments, actions, project proposals, or business case results, the interpretability of IRR results shrinks or disappears altogether because the cash flow streams in these cases may differ substantially from the investment curve profile that IRR expects, and also because the resulting IRRs can differ greatly from real the cost of capital and reinvestment rates. Consequently, there is a case to be made for obeying the Four Commandments of IRR Use:
- Do not use IRR when the net cash flow stream differs substantially from the investment curve profile (early net cash outflows, later net cash inflows).
- Do not use IRR to compare competing cash flow streams whose profiles differ substantially from each other, even if both are roughly "investment curves."
- Do not be tempted to over interpret IRR return rates when IRR differs substantially from the real cost of capital and reinvestment rates.
- Do not even try to find an IRR when the net cash flow stream is entirely positive or entirely negative. There is no IRR for such situations.
The Emperor's New Clothes
In the well known Hans Christian Andersen story, not one adult—including the Emperor himself—is brave enough to "call it as it is." Admitting they cannot see the Emperor's "fine new clothes" would brand them as fools, unfit for their positions—or so they have been told and so they believe. Only the young child cries out: "He's not wearing any clothes!"
A mild form of this kind of vanity may very well be operating in the financial community, and in senior management, where many seem reluctant to expose IRR's many weaknesses, limited applicability, and limited interpretability. For the present, the person called on to support requests, proposals, or plans with IRR is well advised to understand fully what their IRRs mean, what they do not mean, and what can be learned instead from MIRR and other financial metrics.
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About the Author Colin Thompson
Colin is a former successful Managing Director of Transactional/Document Manufacturing Plants, Document Management/Workflow Solutions companies and other organisations, former Group Chairman of the Academy for Chief Executives, Non-Executive Director, Mentor - RFU Leadership Academy, Mentor - Coventry University, Mentor - The Chartered Institute of Personnel and Development, Business Advisor NHS Deanery, author/writer Business Advice Section for IPEX, Graphic Display World, News USA, Graphic Start, plus many others globally, helping companies raise their `bottom-line` and `increase cash flow`. Plus, helping individuals to be successful in business and life in general. Author of several publications, research reports, guides, presentations, business and educational models on CD-ROM/Software/PDF and over 4000 articles/reports and 35 books published on business and educational subjects worldwide. Plus, International Speaker/Visiting University Professor.
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