It’s funny that the IRR – the Internal Rate of Return – is still in use with finance professionals. Actually it is not funny, it is sad, especially when you consider the many flaws that the IRR has. But it is human after all: the IRR looks like a wonderfully simple selection criteria. If a project delivers 15% IRR and my cost of capital is only 10%, then I should invest in this project! And if another project delivers 20% IRR, then I should invest in that one instead! Unfortunately, things are not that simple.
But what is the IRR? It is really hard to find anyone who can explain it in terms that make sense. No surprise there: the IRR is a mathematically defined percentage and most people hate mathematics. By the way: do you know that the IRR is so fuzzy that it can only be calculated by computers (and Excel) using iterative methods i.e. you can simply calculate IRR as a simple sum or ratio of other things. Unlike your beloved NPV, ROIC and the likes.
So what is the IRR once again? The IRR is the discount rate that makes the NPV equal to zero when the IRR is used instead of the WACC in the NPV formula. Why should that be any good? Well, a promising project should have NPV>0 when discounted at the cost of capital (WACC), and the higher the discount rate, the lower the NPV you would expect. So as NPV (IRR) = 0, the IRR tells you how much the WACC would have to be increased to in order to make the project NPV nil, so turn a promising project into one that does not look promising any longer. By the way, I forgot: if expected future cashflows are always positive, then there is no IRR – because you can’t make the NPV nil – unless the IRR is infinite. Put it another way: any project with only positive future free cashflows has an infinite IRR. Great. But confusing.
But why do people use the IRR? The appealing thing about the IRR is that it gives you the feeling of having a safety margin for your WACC. If your WACC is 10% and the project IRR 20%, then it looks like you have 10% point of safety. Sounds great! Especially when you have used a company WACC rather than a project WACC (project WACC are difficult to estimate after all, unless you are Einstein). But single project WACC might be (much) higher than the company WACC (especially if you are looking at a start-up or a turn-around case). So the IRR tells you how much the project WACC would have to be to make the investment unattractive. If you are a venture capitalist, then your project WACC (or your hurdle rate) will often be 30% or more. So a project with an IRR of less than 30% will be unattractive to you. Well, you won’t see many of them in the boardroom (you are a board member, aren’t you) for a start, because as the saying goes: is this project presented to me because it has an IRR higher than 30%, or is this project IRR higher than 30% because it is presented to me?
One of the many problems with the IRR is that it is difficult to relate to and not intuitive at all. If the WACC is 10%, how good is an IRR of 15% versus an IRR of 20%? Well, 20% sounds better than 15%, but if the NPV of the project with the IRR of 15% equal to USD 1bn, and the NPV of the project with the IRR of 20% is USD 10m, which project do you prefer? Do you prefer to be USD 1bn richer or only USD 10m? The former I presume. So assuming all other things (like project risks) being equal, the project with the IRR of 15% is more attractive than the one with the IRR of 20%.
If this is not confusing enough, sorry to confuse you once more: do you know that some projects have multiple IRRs? So which one do you take then?
After so much confusion, we would not want to leave you in the dark. So if you discard the IRR – and you won’t lose much – what do you do then? Our recommendation: forget about the IRR altogether, and focus on value creation instead, using the NPV. Ideally combined with other measures like the cashflow profile, the peak funding requirement, ROE or ROIC, as well as an analysis of project risks.
If you somehow need a margin of safety, then increase your WACC to a (more?) realistic project WACC level and use it to calculate the NPV. In a transaction context (M&A / equity sale) this will put pressure on the transaction price. Buying at a good price is your best margin of safety. Not a convoluted mathematical number that is difficult to interpret.
In case you are not sick enough about the IRR by now, here is an extract from INVESTAURA’s recently published book ‘Business Planning for Managers’ where further food for thought is provided on one of the most misleading and misconceived financial indicator, the IRR.