What are some problems with using IRR? What causes these problems?

Answer 1

IRR or internal rate of return is % rate the company expects from a project's life. IRR is the % rate that makes the net present value of the project = zero. If the IRR is greater than the company's required rate of return, the company should do the project because it will add value to the business.

Problems with IRR are the following:
1) IRR may not maximize wealth because it is not measuring actual $ but percentages above/below the required rate of return. A lower IRR project may provide more $ wealth to the company because it is much bigger than a higher IRR project.
2) IRR will often lead a company to pick the wrong project if projects are mutually exclusive. This is because of project size and timing differences in the cash flows. This is because NPV assumes reinvestment occurs at the NPV rate while IRR assumes reinvestment occurs at the IRR rate. So cash flow earlier in a IRR budgeted project has much more value than later on. In reality it is difficult for a company to reinvest at the IRR rate.
3) If cash flows vary substantially with + cash flow and - cash flow through the project's life, IRR can get you 2 or more IRR rates because with every change from + cash flow to - cash flow you generate another possible IRR. So it becomes unrealistic to evaluate these cash flow patterns with IRR.

Hope this helps you.

Answer 2

What is IRR?