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.
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 comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances.
Admittedly, some of the measure’s deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations—and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards.
We believe that managers must either avoid using IRR entirely or at least make adjustments for the measure’s most dangerous assumption: that interim cash flows will be reinvested at the same high rates of return.