Chapter 4 • Investment appraisal methods
What IRR fails to recognise in Example 4.4 is that if finance is available at
10 per cent the business’s wealth would be more greatly increased by earning
13 per cent on a £10,000 investment than 14 per cent on a £6,000 one. IRR fails to
recognise this because it does not consider value; it is concerned only with percent-
age returns.
l Like NPV, IRR takes full account both of the cash flows and of the time value of
money.
l All relevant information about the decision is taken into account by IRR, but it also
takes into account the irrelevant, or perhaps more strictly the incorrect, assumption
(which we discussed in the first point above) made by IRR.
l IRR can be an unwieldy method to use, if done by hand. This is not a practical prob-
lem, however, since computer software that will derive IRRs is widely available:
most spreadsheet packages are able to perform this function. The trial and error
process, which is the only way to arrive at IRRs, can be very time-consuming,
especially where long projects are involved, if it is done by hand. Computers also
try and err, but they can do it much more quickly than humans, so deriving IRRs is
not usually a great difficulty in practice.
l IRR cannot cope with differing required rates of return (hurdle rates). IRR provides
an average rate of return for a particular investment project. This rate is normally
compared with a required rate of return to make a judgement on the investment. If
financing costs are expected to alter over the life of the project, this comparison
might cause difficulties. The reasons why the required rate may differ from one
year to the next include the possibility that market interest rates might alter over
time. If the IRR for a particular project is consistently above or below all of the dif-
ferent annual required rates of return, there is no difficulty in making the decision.
Where, however, the IRR lies above the required rate in some years but below it in
others, the decision maker has a virtually insoluble problem. This situation poses
no problem for NPV because, as we saw in section 4.2, it is perfectly logical to use
different discount rates for each year’s cash flows.
l The IRR model does not always produce clear and unambiguous results. As
we have seen, the IRR for a particular project is the solution to an equation con-
taining only one unknown factor. This unknown factor is, however, raised to
as many powers as there are time periods in the project. This is a mathematical
phenomenon that relates to the solution to any equation where there are unknowns
raised to the power of two or higher. Arising from this phenomenon, any project,
therefore, that goes beyond one time period (in practice one year) will usually
have as many IRRs as there are time periods. In practice, this is not often a pro-
blem because all but one of the roots (IRRs) will either be unreal (for example,
the square root of a negative number) or negative themselves, and therefore of no
economic significance. Sometimes, though, all of the roots can be unreal so that
there is no IRR for some projects. Sometimes a project can have more than one real
root (IRR).These problems of multiple and no IRRs can arise with projects that have uncon-
ventionalcash flows. Projects A and B in Example 4.4 have conventional cash flows in
that, chronologically, a negative cash flow is followed by positive ones, that is, there is
only one change of sign in the cumulative cash flow total (from negative to positive
between years 1 and 2 in both projects).