8. Limitations of IRR
If using IRR, it's important you understand the limitations of this valuation method. In this lesson I cover a few the major limitations of IRR
Limitation #1: Multiple answers
- For some investments, NPV = 0 at more than one discount rate.
- As a result, we can get multiple answers for IRR
- This tends to happen when we have negative cashflows during a project
Limitation #2: Discount rate can't vary during project
- Certain investments (e.g. technology products) may have a higher risk level in later years
- IRR cannot vary the discount rate over time, it simply gives one annual rate
- NPV on the other hand can deal with varying discount rates using the discount factor
=PRODUCT(range): Multiplies together each number with selected range
SHIFT + →: Select next cell
ALT + E , S , F: Paste formulas
F2: Jump back inside a formula
F4: Anchor cells
In the previous lesson, I explained that IRR contained a big inbuilt assumption that your reinvest cash flows are the same rate of return as the original investment.
In addition to this, IRR can also give you multiple results under certain circumstances. Or, no result at all.
To see this in action, let's look at the following investment with cash flows over four years.
The net present value for a discount rate of 10% is $12.
Off camera, I’ll run a sensitivity analysis for the NPV at various discount rates.
When I plot these results on a chart, you can see that two points have an NPV equal to zero, and hence, we have two IRR values.
Whenever we have project cash flows that change sign twice, we tend to have multiple IRR answers.
While it’s normally quite straightforward to pick the correct IRR, it can cause confusion in some cases.
Another limitation of IRR is its inability to change the risk level during the project.
On sheet two, I have a four year technology project and for each year the cash flows have gradually higher levels of risk, due to the introduction of new competing technologies.
By the end of the forth year, the discount rate has jumped from 5% up to 15%.
To implement this for NPV, is quite straightforward.
For each year, we calculate what's called the discount factor.
And the discount factor is simply one divided by one plus R for that particular year.
And so I'll simply go to this cell and write “=one”, divided by one plus the discount rate.
And I'll copy this formula across for the remaining cells.
To now get the discounted cash flows for each year, we simply multiply together the discount factors for each year, up to the current year, by the annual cash flow.
o do this, I'll use the PRODUCT function.
I'll start in the last cell and I'll write “=”, select the annual cash flow, and this will be multiplied by product function and this will accept all of the discount factors, but I’ll anchor the first discount factor because I want to paste this function for the remaining cells.
So I'll press F2 to jump back into the formula, and then F4.
And I'll close the bracket and press Enter.
I can now copy and paste for the remaining cells.
And this gives me a net present value of $23,634.
With IRR however, there’s no facility to change the discount rate during the investment, and it will only provide us with a consistent rate of return for every year.
Despite these weaknesses, I would still recommend that you calculate IRR when making investments.
This is partly due to the fact that most businesses still rely on IRR, but also because it doesn't require any assumptions for discount rates, reinvestment rates, etc.
It's also very easy to calculate, and as you will see in a later lesson, sometimes more useful than NPV.
In the next lesson, I'll show you one more income based valuation metric that you should also calculate for every investment, and it’s called the payback period.