Internal Rate of Return: A Cautionary Tale
Tempted by a project with high internal rates of return? Better check those interim cash flows again.
The McKinsey Quarterly - McKinsey & Co. October 20, 2004
Maybe finance managers just enjoy living on the edge. What else would explain their weakness for using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects. (John Robert Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.)
Our own research underlined this proclivity to risky behavior. In an informal survey of 30 executives at corporations, hedge funds, and venture capital firms, we found only 6 who were fully aware of IRR's most critical deficiencies. Our next surprise came when we reanalyzed some two dozen actual investments that one company made on the basis of attractive internal rates of return. If the IRR calculated to justify these investment decisions had been corrected for the measure's natural flaws, management's prioritization of its projects, as well as its view of their overall attractiveness, would have changed considerably.
So why do finance pros continue to do what they know they shouldn't? IRR does have its allure, offering what seems to be a straightforward compa ...