Internal rate of return: Good and bad features, and a new way of interpreting the historic measure

Abstract

IRR, a widely used profitability measure, is the Discount Rate that yields Net Present Value (NPV)=0 for a stream of positive and negative cash flows, at least one of each sign and with no explicit financing payments. A big disadvantage is lack of parameters, such as a project finance rate or the enterprise rate (ER), i.e., Return on Investment of the overarching investment group to serve as a measure of opportunity cost. The coupled metrics proposed earlier by the author— NPVproject and NPV%–do not suffer these disadvantages, so IRR is analyzed in terms of NPV%. Useful information can be obtained from a projection of IRR values onto the NPV%, ER plane revealing the sensitivity of IRR to risk under meaningful operating conditions.