Internal rate of return (IRR)
Imagine an investment that requires a payment of Dollars 5,000 up front and then produces positive cash flows of Dollars 3,000 in years two to 10. At a 10 per cent discount rate, this project will have a positive net present value of just over Dollars 11,160 and an internal rate of return of 59 per cent. Now assume the investor can sell out at fair value in year three, receiving Dollars 14,605 (the NPV of the cash flows in years four to 10). The project's overall NPV remains exactly the same. But the IRR more than doubles to 120 per cent - even though no extra value has been created.
This is hardly news. But all too often, it creeps into practice: IRR is the private equity industry's main yardstick for judging performance, raising funds and rewarding managers. Indeed, the sector makes much of its superior, 25 per cent, returns. Yet as the example shows, such IRR-based numbers can be
artificially boosted by extracting cash early - through trade sales, listings or recapitalisations. Indeed, the theoretical investor could accept as little as Dollars 5,000 in year three, thereby destroying considerable shareholder value, and still trumpet an IRR of over 59 per cent.
IRR calculations implicitly assume that interim cash flows are reinvested at the original IRR. It would be more realistic to assume, as NPV does, reinvestment at the cost of capital. Because it is intuitive and easy to calculate, IRR will remain popular. But it should not be used in isolation and investors should recognise its flaws.
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