This lesson examines the Internal Rate of Return method and its modified version. It covers the calculation of IRR, its decision rules, and the specific problems that can arise when using IRR, particularly with mutually exclusive projects.

• The IRR Method: The internal rate of return is the discount rate that results in a net present value of zero. It equates the present value of future cash flows to the initial investment.

• The IRR Decision Rule: A project is accepted if its internal rate of return is greater than the required rate of return (hurdle rate). If the IRR is less than the required rate of return, the project should be rejected.

• Advantages of IRR: The IRR method incorporates the time value of money and considers all relevant cash flows. It provides a measure of profitability in percentage terms, which is intuitive for many managers.

• IRR Limitations – Crossover (Multiple IRR) Problem: When cash flows for a project change sign more than once (alternating between negative and positive), the IRR can have multiple mathematically valid solutions. For projects with a crossover problem, the IRR cannot be reliably used.

• IRR Limitations – Mutually Exclusive Projects: When evaluating mutually exclusive projects, the IRR method can lead to incorrect rankings due to two problems:

  • The Size Problem: When projects are of different sizes, IRR may rank a smaller project with a higher percentage return above a larger project with a lower percentage return but greater absolute wealth creation.

  • The Reinvestment Rate Problem: IRR assumes that cash flows from the project are reinvested at the IRR itself, while NPV assumes reinvestment at the discount rate.

• Modified Internal Rate of Return (MIRR): MIRR addresses some of the limitations of the standard IRR by assuming reinvestment at the cost of capital.

• NPV vs. IRR: For mutually exclusive projects, NPV is generally preferred over IRR because it consistently selects the wealth-maximizing alternative.