Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

9-5b ADVANTAGES OF THE IRR METHOD

The question of how to rank investments that offer different IRRs points to an important potential

weakness of this method. However, before considering the problems associated with IRR analysis, let

us discuss the advantages that make it one of the most widely used methods for evaluating capital

investments.

■ The IRR makes an appropriate adjustment for the time value of money. The value of a dollar received

in the first year is greater than the value of a dollar received in the second year. Even cash flows that

arrive several years in the future receive some weight in the analysis (unlike payback, which totally

ignores distant cash flows).

■ The hurdle rate is based on market returns obtainable on similar investments. This takes away some

of the subjectivity that creeps into other analytical methods, like the arbitrary threshold decisions

that must be made when using payback or accounting rate of return, and it allows managers to make

explicit, quantitative adjustments for differences in risk across projects.

■ The ‘answer’ that comes out of an IRR analysis is a rate of return, which is easy for both financial and

non-financial managers to grasp intuitively. As we will see, however, the intuitive appeal of the IRR

approach has its drawbacks, particularly when ranking investments with different IRRs.

The IRR technique focuses on cash flow rather than on accounting measures of income.

Despite its advantages, the IRR technique has some quirks and problems that in certain situations should

concern analysts. Some of these problems arise from the mathematics of the IRR calculation, but other

difficulties come into play only when companies must rank mutually exclusive projects. Two or more projects

are mutually exclusive if accepting one project implies that the others cannot be undertaken. If the IRRs

of several projects exceed the hurdle rate, but only a sub-set of those projects can be undertaken, how

does the company choose? It turns out that the intuitive approach, selecting those projects with the

highest IRRs, sometimes leads to bad decisions.

9-5c PROBLEMS WITH THE INTERNAL RATE OF RETURN

There are two classes of problems that analysts encounter when evaluating investments using the IRR

technique. The first class can be described as mathematical problems, which are difficulties in interpreting

the numbers that one obtains from solving an IRR equation. These problems occur infrequently in

practice, but you should be aware of them. For example, consider a simple project with cash flows at

three different points in time:

CF 0 CF 1 CF 2

0 1 2

years

CF 0 is the immediate cash flow when the project begins, and CF 1 and CF 2 are cash flows that occur

at the end of years 1 and 2, respectively. Note that conceptually the values of CF 0 , CF 1 and CF 2 could be

either positive or negative. Solving for this project’s IRR means setting the net present value of all these

cash flows equal to zero:

NPV CF

CF

r

CF

r

$0

11

0

1

1

2

2

()()

==+

+

+

+

Notice that this equation involves terms such as [1 ÷ (1 + r)]^1 and [1 ÷ (1 + r)]^2. In other words,

this is a quadratic equation. Solving a quadratic equation can result in outcomes including: (1) a unique

A company’s hurdle rate is 10%,

and most of its investments

earn at least a 20% IRR. If

it accepts a project with a

15% IRR, won’t this lower its

average return and disappoint

the company’s investors?

thinking cap

question

mutually exclusive

projects

Two or more projects for which

accepting one project implies

that the others cannot be

undertaken