IRR Rules And Caveats
Internal Rate of Return Rules and Caveats
Fundamental Rules
- For go/no-go decisions on a single project without constraints: go if internal rate of return is greater than appropriate discount rate.
- For choosing among alternatives, USUALLY you can choose the project with the highest IRR, BUT
- can depend on discount rate — different project may be preferred at one discount rate than another and IRR can obscure this
- may mask the fact that doing nothing may be better option
- Variation, "undertake project if IRR > X" can lead to indeterminate results under some conditions
Conclusions
IRR approach only works if
- no budget constraints
- projects do not preclude one another
- net returns start negative and then get positive (more costs up front)
And so, the BOTTOM LINE: choose mix of projects yielding highest present value.