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One of the limitations of IRR is that it assumes that the cash flow earned from the project is being reinvested within the project at the IRR rate
(MIRR Technical Article: IRR techniques assumes cash flow generated by a project are reinvested within the project)I would like to know how the “reinvestment” work.
However, I did some research and found an article that’s says otherwise. Would like to know if his calculations and justifications are valid.
Thank You
The only sense in which it is a limitation is when using the IRR in order to choose between two investments.
Suppose, for example, you had one investment that required an outlay of 100,000, had a life of 5 years, and an IRR of 12%, and had a second investment that required an outlay of 100,000, had a life of 20 years and an IRR of 10%.
Then you cannot automatically say that the first investment is better simply because it has a higher IRR. It might be better to choose the second investment because although the ‘return’ is a little lower, you are getting it for a much longer period.
The only time you could certainly say that the first one (with the higher IRR) is better would be if you were able in both cases to reinvest the inflows at the IRR, in which case you would be getting either 12% or 10% for ever. Then the one with the higher IRR would definitely be better.
The article you linked to does not seem to really understand that 🙂
(Please, however, do not post links to other websites on this website 🙂 )
I see, now I get it. Thank you so much for clarifying.
Much apologies for the posting an external link, will take note of it.
Once again, Thank you for your time.
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