IRR vs. NPV: Why a Popular Investment Evaluation Method Can Mislead You

Posted by Dmytro Dodenko

How to avoid mistakes when choosing an investment project?

The strategic goal of any business is maximizing shareholder wealth. Since every firm’s resources are limited, management’s ability to make sound investment decisions becomes a key factor for long-term success. This goal is achieved through the careful selection of investment projects that create real value.

This requires reliable evaluation criteria. The “Gold Standard” in capital budgeting is Net Present Value (NPV). This method shows how much future cash flows, discounted back to the present day, exceed initial investments. The rule is simple: if NPV > 0, the project should be accepted, as it directly increases the company’s value.

However, managers often prefer another metric – the Internal Rate of Return (IRR) –because it expresses the result in familiar percentages. But behind this simplicity hide serious “pitfalls” that can lead to catastrophically wrong decisions.

What Is IRR and Why Is It Attractive?

The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment project equals zero. Simply put, IRR shows the maximum cost of capital at which the project remains break-even.

The IRR Rule: A project should be accepted if its IRR exceeds the cost of capital (or the return on alternative investments).

For example, if a project with an investment of -4,000 and cash flows of +2,000 and +4,000 has an IRR of 28%, and the cost of capital is 10%, then since 28% > 10%, the project looks attractive. This seems logical, but the devil is in the details.

Four “Pitfalls” of the IRR Method Every Manager Should Know

Despite its widespread use, IRR has several serious limitations. Misunderstanding these “pitfalls” can lead to unprofitable decisions.

Pitfall #1: Lending or Borrowing?

The standard IRR rule works only for classic investments (first a negative cash flow, then positive ones). If the cash flow structure is different, the rule can yield the opposite result.

Let’s consider two projects:

• Project A: You invest $1,000 today (C₀ =−1000) and receive $1,500 in a year (C₁=+1500).
• Project B: You receive $1,000 today (C₀=+1000) and pay back $1,500 in a year (C₁=−1500).

For both projects, IRR = 50%. However, their economic substance is radically different:

1. Project A is an investment (lending) at 50%. This is a profitable operation if your cost of capital is less than 50%. The standard IRR rule works here.
2. Project B is borrowing at 50%. This is an unprofitable operation if you can raise capital cheaper elsewhere. In this case, a high IRR (50%) is a bad signal. Project B should only be accepted if its IRR is lower than the cost of capital.

Conclusion: For projects that start with a cash inflow, the standard IRR rule must be applied in reverse.

Pitfall #2: Multiple IRR Values

If cash flows change signs more than once (e.g., –, +, +, –), a project can have multiple IRR values or none at all, making the criterion absolutely unsuitable for analysis.

A classic example is a project requiring significant costs not only at the start but also at the end. Imagine a mining company that is required to spend millions on land reclamation after the deposit is depleted. Its cash flow would look like this: Negative (Investment) -> Positive (Operating Profit) -> Negative (Reclamation Costs).

For example, a project with initial investments, mid-term income, and end-term costs might have an IRR of both -50% and 15.2%. Which value is correct? There is no answer.

In such cases, NPV remains the only reliable criterion.

Pitfall #3: Mutually Exclusive Projects (The Scale and Timing Problem)

Using IRR to select one of several mutually exclusive projects can lead to the wrong choice.

The Scale Problem

Imagine you are choosing between two mutually exclusive projects, D and E:

Project D with an IRR of 100% may generate less actual money (NPV = +8,182) than Project E with an IRR of 75% (NPV = +11,818). Choosing based on the higher IRR will lead to a loss of value.

The Timing Problem

Imagine you are choosing between two projects, G and H (Projects Ж and З in the original). They require identical initial investments but generate cash flows over different time periods:

Project G, which generates cash flows faster, has a higher IRR (33% vs. 20%). However, the long-term Project H has a significantly higher NPV at a 10% rate. IRR favors projects that return investments quickly, ignoring long-term value.

Pitfall #4: The Unrealistic Reinvestment Rate Assumption

The IRR method implicitly assumes that all cash flows generated by the project during its lifecycle can be reinvested (i.e., invested again) at that specific found IRR, rather than at any other, more realistic rate.

This is particularly unrealistic for projects with a high IRR (e.g., 100%). It is highly unlikely you can consistently find other opportunities yielding 100%.

The NPV method, in contrast, makes a more realistic assumption that money is reinvested at the opportunity cost of capital.

Modified IRR (MIRR): An Attempted Fix That Highlights the Flaws

To address some of IRR’s problems, particularly the issue of multiple values, the Modified Internal Rate of Return (MIRR) was invented. This method achieves its goal by “modifying” the cash flows—for example, by discounting all negative cash flows to time zero.

However, the very existence of MIRR only underscores the fundamental weaknesses of the original IRR concept.

Why invent a complex “prosthetic” to repair an unreliable tool when a simple, elegant, and always reliable method – NPV –is right at hand?

Conclusion: Why Is NPV the “Gold Standard”?

The analysis of IRR “pitfalls” clearly demonstrates why the NPV rule remains the most reliable investment evaluation criterion.

Unlike IRR, the NPV method possesses fundamental advantages:

1. It Correctly Accounts for the Time Value of Money.
2. It Is Objective: It depends solely on projected cash flows and the opportunity cost of capital.
3. It Is Additive: This means the NPV of a portfolio of projects equals the sum of the NPVs of the individual projects comprising it. (Value additivity principle).
4. It Is Flexible: The NPV method allows the use of different discount rates for cash flows of different periods (term structure of interest rates). This makes it much more powerful and accurate for long-term projects, especially in an unstable economy.

While IRR can be a useful auxiliary tool, it should never replace NPV as the primary criterion for making investment decisions.