Hi, John, could you explain how does multiple IRRs occurred? What does it mean that reinvestment at cost of capital rate, or reinvestment at IRR rate? Since MIRR is better, why do we still use IRR? Thanks.
A ‘normal’ project involved an outflow at the beginning and then inflows. There is only one IRR and the higher the cost of capital the less the NPV.
However, if you start with an outflow, then have inflows, but then have more outflows, then it is possible to have two IRR’s. (it does not always happen – it depends on the amounts involved – but it can happen). It is because you start of investing money but then it turns into you effectively borrowing money.
Each time the direction of the flows changes (from inflow to outflow, or vice versa) then there is potentially one more IRR.
The business about assuming reinvestment, is saying that if we were to choose between projects based on their IRR’s then it would be assuming that we were going to continue to get the same return for ever (i.e. that the receipts would be reinvested to get the same return).
MIRR is assuming the same idea, but the the money is reinvested at the cost of capital.
It is not really that MIRR is better, but just that comparing MIRR’s of two projects would come to the same decision as comparing the NPV’s (whereas that might not be the case with IRR’s).
However, the real benefit of the IRR is not looking at it as a rate of return, but the fact that it gives a breakeven cost of capital if we are not certain of the cost of capital (which in practice we never are).
Another weakness of IRR, which I don’t quite understand. Could you explain, sir?
“IRR Cannot be used to compare mutually exclusive projects.”
Imagine you had two projects to choose from.
One requires an investment of 10,000 and has an IRR of 15%.
The other requires an investment of 100,000 and has an IRR of 14%.
Which would you rather have – a return of 15% but only on 10,000, or be able to invest 100,000 and get a return of 14%.
Surely you would rather do the second one.
With NPV’s there is no problem – you choose the one with the higher NPV (the highest cash surplus after accounting for the interest).
Comparing IRR’s can sometimes lead to the wrong decision (as in the baby example above).
Hello John in the above example you said about selecting the one with lower return. Why we should select the second one if the rate of return for first project is 15% ?
15% of 10,000 is 1,500, 14% of 100,000 is 14,000. How much return do you prefer?
In mutually exclusive projects with IRR approach we have to see not only rate of return but also amount of return too…so in above example amount of return is more with lower rate (i.e 14%)….
One an other reason for this problem is IRR is relative measure (%s) whereas NPV is absolute measure (no confusion of rate-direct amount in $)
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