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Disadvantages of the IRR Method
IRR can't be used for exclusive projects or those of different durations; IRR may overstate the rate of return.
Learning Objective

Describe the disadvantages of using IRR for capital budging purposes
Key Points

The first disadvantage of IRR method is that IRR, as an investment decision tool, should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in.

IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR.

IRR does not consider cost of capital; it should not be used to compare projects of different duration.

In the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values.
Terms

mutually exclusive
Describing multiple events or states of being such that the occurrence of any one implies the nonoccurrence of all the others.

duration
A measure of the sensitivity of the price of a financial asset to changes in interest rates, computed for a simple bond as a weighted average of the maturities of the interest and principal payments associated with it
Full Text
The first disadvantage of the IRR method is that IRR, as an investment decision tool, should not be used to rate mutually exclusive projects but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints).
In addition, IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project. When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate–sometimes very significantly–the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows.
Moreover, since IRR does not consider cost of capital, it should not be used to compare projects of different duration. Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow.
Last but not least, in the case of positive cash flows followed by negative ones and then by positive ones, the IRR may have multiple values.
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Key Term Reference
 capital
 Appears in this related concepts: The Five Cs of Credit, Moving from ShortRun to LongRun, and Defining Capital
 cash flow
 Appears in this related concepts: Cash Flow, Interpreting the NPV, and Interpreting Overall Cash Flow
 cost of capital
 Appears in this related concepts: Advantages of the Payback Method, Defining the Payback Method, and Cost of Capital Considerations
 discounted cash flow
 Appears in this related concepts: Valuing the Target and Setting the Price, Valuing the Corporation, and Ranking Investment Proposals
 interim
 Appears in this related concepts: Reinvestment Risk, Methods of Paying Dividends, and Overview of Derivatives
 investment
 Appears in this related concepts: Agencies, The Role of the Financial System, and Shifts in investment due to shocks
 reinvestment rate
 Appears in this related concepts: Calculating the NPV, The Yield Curve, and Modified IRR
 return
 Appears in this related concepts: Dollar Returns, Comparing the Fields of Finance, Economics, and Accounting, and Disadvantages of the Payback Method
 shareholder
 Appears in this related concepts: Introduction to Corporate Social Responsibility, Arguments for and against Corporate Social Responsibility, and Types of Stakeholders
Sources
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Cite This Source
Source: Boundless. “Disadvantages of the IRR Method.” Boundless Finance. Boundless, 02 Jul. 2014. Retrieved 20 May. 2015 from https://www.boundless.com/finance/textbooks/boundlessfinancetextbook/capitalbudgeting11/internalrateofreturn93/disadvantagesoftheirrmethod404874/