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Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR): Definition, Meaning, and Usage.

Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Revised 201302-06. Internal Rate of Return (IRR) is a financial metric for cash flow analysis, often used for evaluating proposed investments, funding requests, acquisitions, or the results of business case analysis. Like several other cash flow metrics (such as net present value, payback period, and return on investment), IRR takes an "investment view" of expected financial results. This means, essentially, that the magnitude and timing of cash flow returns are compared to the magnitude and timing of cash flow costs. Each of these financial metrics§compares returns to costs in its own way and each carries a unique message about the value of the investment. IRR analysis begins with a cash flow stream, a series of net cash flow§ figures expected to follow from the investment (or action, acquisition, or business case scenario). The expected cash flow stream for IRR analysis might appear something like this: Each bar represents the net of inflows and outflows for one twomonth period. The complete set of net cash flow events is a cash flow stream. If this cash flow stream represents one investment, another investment might show a different cash flow profile. IRRs for each investment can be compared to help decide which is the better business decision. Other things being equal, the investment with the higher IRR is viewed as the better choice. Notice especially the shape, or profile of this example cash flow stream. The figure shows a typical investment curve. Net cash outflows at the outset and net cash inflows in later periods mean that costs initially exceed incoming returns, but if the investment performs as expected, returns eventually outweigh the costs. The IRR metric, in fact, "expects" this kind of cash flow profile—early costs and later benefits. When the cash flow stream has this kind of profile, an IRR can probably be found and usefully interpreted. When the cash flow stream deviates substantially from this profile, however, it may not be possible to find an IRR for the stream. Or, other strange IRR results may appear, such as multiple IRRs for the same stream, or a negative IRR for the cash flow stream. In such cases, the resulting IRRs are either very difficult to interpret or meaningless. Most people in business have heard of "internal rate of return." Some are required by

It may be more surprising. this entry also presents the modified internal rate of return(MIRR). that IRR is a more "objective" metric than NPV. Controllers. multiple.Finding IRR: Can IRR be calculated?§ • IRR re-defined: Why is it called internal rate of return?§ . There is a widespread belief in the financial community. in comparing IRR to other financial metrics. Many also believe that IRR allows investment returns to be compared readily with inflation.First IRR Interpretation: IRR as a measure of risk § . and the role of the discount rate§(interest rate) in determining NPV: IRR Definition 1 (textbook definition): The internal rate of return (IRR) for a cash flow .thier financial officers to produce an IRR to support budget requests or action proposals.Negative. net present value (NPV)§. • Internal rate of return (IRR) defined and illustrated with an example§ . Many organizations establish an IRR hurdle rate§. to learn that research on professional competencies finds consistently that most of the same financial specialists who require IRRs with proposals or funding requests are themselves largely unaware of IRR's serious deficiences and unprepared to explain its meaning and proper use. an IRR view of the cash flow stream is essentially an investment view: paid out funds are compared to returns. For that reason. current interest rates.IRR vs. whereas IRR is determined eintirely by the cash flow figures and their timing. this entry puts a special emphasis on understanding IRR meaning and interpretation. a more easily interpreted alternative to the better known IRR. Buy vs. ROI. and Payback Period§ . however. that is. for instance. and impossible IRRs§ Internal rate of return (IRR) defined and illustrated with an example As the word "return" in its name implies. buy and other problem IRR results§ .Lease vs. and financial investment alternatives. and other financial specialists. MIRR.IRR disgused as yield to maturity (YTM) for bond investing§ • Lease vs. And. because NPV depends on an arbitrarily chosen discount rate. It should no surprise to learn that most business people who are not in finance have a limited or poor understanding of IRR and its meaning. IRR§ . an IRR rate that must be reached or exceeded by incoming proposals if they are to be approved and funded. as well as common misconceptions and misuses of IRR. IRR is in fact a favorite metric of many CFOs. The best known IRR definition explains this comparison in terms that call for a basic understanding of discounted cash flow concepts present value§. NPV.Second IRR interpretation: Financing costs and reinvestment gains § • Modified Internal Rate of Return (MIRR): A better metric?§ • Internal rate of return compared to other financial metrics§ .

Case B (yellow bars) has smaller returns at first. The first table row shows net cash flow each year. but B's returns grow each year. The analyst will thus compare two different kinds of investments with the same metric. The expected net cash flow streams for A and B are as follows: Both cases call for an initial cash outlay of $220. Case A. show an IRR of 30. Many ask: "What doesthat tell me about returns and costs? A first interpretation of IRR meaning is illustrated with an example. Case A (blue bars) has large early returns but these diminish year by year. to address questions like these: Which is the better investment? Which is the better business decision? The net cash flow figures above. B's profile could result from investing in a product launch that returns greater profits each year. Case A brings a net gain of $200 over 7 years while case B brings a net gain of $240 over the same 7 years. 30. Only one of the above cash flow streams is shown here.8% for Case B. and the second row shows the discounted values (present values) of the same cash flows. note in the image below how the two cash flow streams streams differ: Both streams have the investment curve profile described above. can be less than satisfying when first heard. . Consider two proposed investments compting for funding: Case A and Case B. Before finding IRRs and other metrics.stream is the interest rate (discount rate) that produces a net present value of 0 for the cash flow stream. Discounting is applied using the IRR rate found by the analyst for this cash flow stream. That definition. A's profile could represent an investment in an income producing asset that becomes less productive or more costly to maintain each year.6% for Case A and an IRR of 20. The next table and figure below show the result of applying IRR Definition 1 (the discount rate that brings an NPV of 0).6%. IRR. however. when analyzed with a spreadsheet function or another IRR program.

That is. Other things being equal.6%. First IRR interpretation: IRR as a measure of risk In the example above. One reason for this conclusion is that a higher IRR indicates less risk. Case A or Case B? Case A has an IRR of 30. .  For the Investment A cash flow. the prevailing discount rate (which includes an inflation component and a risk component) would have to rise all the way to 30. find this first interpretation of IRR of little value for evaluting and comparing proposed investments. You may just be able to see or imagine that the heights of the seven positive (upward pointing) light blue bars starting with Yr 1 add up exactly to the height of the one negative (downward pointing) light blue bar at "Now. • Light blue bars are present values of the same cash flows at the IRR discount rate of 30. IRR indicates just how high inflation rates or risk probabilities have to rise in order to eliminate the present value of this investment. however. Case B has an IRR of 20. which is the better Investment. the one with the higher IRR (Case A) is considered the better choice. the sum of positive PVs excactly cancels the sum of negative PVs. a comparison of IRR with other cash flow metrics. at the IRR discount rate. more useful IRR interpretation. Most people. move torward a second. the modified internal rate of return (MIRR). The chart at left also shows the same thing in visual terms. The sections below.6%. and a description of a more easily interpreted metric.  The B investment would lose all present value if the discount rate rose to 20. and using IRR as the decision criterion.Notice in the table that this discount rate leads to a total present value (NPV) of 0.8%.6% to drain this investment of present value. therefore.8%." In other words. • Dark blue bars are future valuenet cash flows for Case A .

It then keeps changing the rate until it finds a rate that produces a 0 NPV. These are plotted below.6%." IRR can be found either by graphical analysis or—as Excel does—by "trial and error" (more precisely. there is no easily applied analytic solution to the above request. Case A's NPV reaches 0 at a discount rate of 30. using end of period discounting: The "FVs" in the formula are the net cash flow figures for each year. then solve the formula for i. The table shows the calculated NPV values. However. i = IRR when NPV = 0. However. by "successive approximations").Finding IRR: Can IRR be calculated? Other cash flow metrics such as NPV. increasing discount rates brings lower NPVs for both streams. assuming you have the proper input data. In fact. and IRRB = 20. For Case A and Case B above. Either way. NPV was calculated for A and B cash flow streams at 10 different discount rates. the verbal IRR Definition 1 above does not lend itself readily to presentation in formula form. and it is more accurate to say that IRR is "found" rather than "calculated. As you would expect. IRRA = 30. showing the relationship between discount rate (horizontal axis) and resulting NPV (vertical axis). the software starts with an arbitrarily chosen discount rate and finds the NPV for a given cash flow stream.8% Instead of finding a graphical solution for IRR. can be calculated directly from simple formulas. n = 7 (7 periods). while B's NPV reaches 0 at a discount rate of 20. The person who wants a "formula" for IRR can be handed the above formula along with the FVs (net cash flow values) and then asked to do the following: Set NPV equal to 0. Consider first the plotting data for a graphcial IRR solution: Using the formula above. so that the IRR result . most people use Microsoft Excel or a preprogrammed calculator.8%. ROI. This occurs very quickly.6%. Therefore. and even payback period. The best that can be done for producing an IRR formula is this: Consider the formula for calculating net present value (NPV) for a cash flow stream.

The example below shows how IRR can be defined as the interest rate that balances these two factors. and 2 Incoming returns will be reinvested for the time remaining until the last cash flow event. These could be. IRR Definition 2: The internal rate of return (IRR) for a cash flow stream is based on two assumptions: 1 There is a financing cost (or opportunity cost) for using the funds to make the investment.1) The spreadsheet cell with this formula shows the IRR for a range of cells with net cash flow figures in cells B3 through B10. for example. The analyst will probably format the spreadsheet cell as a percentage.6% IRR re-defined: Why is it called internal rate of return? The textbook IRR Definition 1 above explains how to find an IRR but says very little about what it represents. one that refers investment financing costs and reinvested returns. The analyst. Investment costs will be financed across the time until the final cash flow event. for instance. The guess is simply a starting discount rate for calculating NPV on the first iteration and it can be almost anything or even omitted.seems to appear as soon as the data are entered. might enter the Excel IRR function into a formula like this: =IRR (B3:B10. . so that the IRR result looks like this: 30.1" figure is simply the analyst's first "guess" at the IRR. IRR's more important meaning is easier to understand in terms of another definition. IRR is then defined as the single interest rate (for financing costs and for reinvestment earnings) that sets the total gains exactly equal to total costs. the eight cash flow values for Case A in the example above The ". Cash flow figures in blue cells are from example Case A above. .

that the company's real reinvestment rate is closer to 8%. something like 30.428. The conclusion is most supportable when the IRR rate is close to actual cost of capital and actual reinvestment rate. The IRR for this cash flow stream is thus 30.63% produces an NPV of 0 for the cash flow stream. Case A above. Notice especially that cash flow stream A expects large returns in the first and second years of the 7-year investment (that is. This comparison.63%. Therefore [the reasoning goes].6%. Excel's IRR function has been entered in the yellow cell below Year 7 net cash flow and it reports that a discount rate of 30. assume that the initial cash outflow of $220 is borrowed and financed at the same 30. Second IRR Interpretation: Financing costs and reinvestment gains The second-definition example above should begin to suggest a reason that financial people look to IRR and often trust it as an important decision criterion: IRR has built into it the presumption that investment costs (opportunity costs or borrowing) are financed at a cost. earning additional gains. while returns represent earnings at a much higher rate. It is easy to overinterpret or misinterpret IRR at this point. Our real cost will be subject to rates closer to our cost of capital.63% annual rate. however. depending on the company's actualfinancing cost rates (or opportunity cost rates) and the actual reinvestment rates to be applied. at an annual interest rate of 30. for instance. an initial cash outflow of $220 (at "Now") represents initial investment costs. The IRR rate exactly balances total investment costs with total investment gains." In reality. Cash flow stream B. Each year after that.428. that conclusion may or not be supportable. for example. This reasoning can grossly overstate the value of investments like.17 (initial cash outflow plus financing). even though the cash flow stream has an IRR of 30.17 (inflows + interest earned).In the example.63%. and that incoming returns are reinvested.6% for example—many are tempted to reason as follows: "For this investment. but when real investment returns are compared . probably less than 10%. The conclusion is most likely misleading or wrong when IRR is quite different from actual cost of capital and reinvestment rates. we will not actually borrow (or pay an opportunity cost) at the IRR rate. Now. This view provides meaning for another IRR interpretation. the investment is a net gain because financing rates will really be under 10%. has to be interpreted carefully. Consider first the interest earned by re-investing the incoming cash flows from Years 1 through 7. namely that the analyst will compare the IRR rate to actual financing rates and actual reinvestment rates. the investment brings positive net cash flow returns. Suppose. on the other hand has a lower IRR than A. The example shows shows the total cost of repaying this loan is also $1. the total seven year gains would be $1. this long term of high-rate reinvestment will be absent. If each incoming return is reinvested with for the remaining years." or "biased" towards the early years). Investment A is "front loaded. The high IRR assumes year 1 and year 2 gains will be reinvested at 30.6% for all the remaining years but in fact. When a proposed investment produces IRR's like those shown above—30.6%.

In brief. .08)5 + $80·(1. . because IRR can differ from the actual financing and reinvestment rates. Subtracting 1. For example cash flow stream A using a reinvestment rate of 8% .0 from the resulting root yields MIRR." and second. .6% Investment Case B: IRR = 20. here 7. but the MIRR calculation also requires as input a financing rate and a reinvestment rate. FV (Positive CFs) = $120·(1. MIRR for this example is based on a reinvestment rate of 8% and a financing rate of 6%: Investment Case A: IRR = 30.08)3 + .93 + $108. B in fact has less "missing" returns of this kind than A. The radical sign calls for the nth root of the Future value/Present value ratio. Here for comparison are the IRR and MIRR results for example Cases A and B from above§. Present values§ of the cash outflows are calculated using the financing rate. Input data for MIRR include the same net cash flow figures as IRR. as shown. MIRR—unlike IRR—can be computed directly from a formula: Future values§ of cash inflows are calculated using the reinvestment rate. therefore. However.28 + $40. . .08)1 + 10·(1. and (b) when comparing two cash flow streams with different profiles as in the example above. buy" comparisions§. stream A is front loaded and stream B is "back loaded. using IRR to assess the magnitude of the net gain is problematic.to the reinvestment earnings presumed by the IRR.08)6 + $100·(1.00 = $587.91 . but both MIRR values are much closer to each other than are the two IRR values. nis the number of periods.82 + $21.8% MIRR = 15.08)0 = $190. Modified Internal Rate of Return (MIRR): A better metric? The meaning of IRR magnitude is difficult to interpret. this solution is readily available as the modified internal rate of return (MIRR) metric. The latter point (b) is illustrated again in the discussion below on IRR in "Lease vs. It is natural to ask.1% MIRR = 14. especially when (a) IRR greatly exceeds cost of capital and the real reinvestment rate.7% Notice immediately that Case A also has a higher MIRR value than Case B.42 + $146.84 + $69. +35·(1·08)2 + $20·(1.60$ + $10. it is reasonable to view a proposed investment as a net gain when IRR is greater than the company's cost of capital. . IRR overstates the real value of investment A far more than it overstates the value of investment B for two reasons: First. The full meaning of MIRR is easier to explain after showing how the MIRR results are derived. "Why not calculate an internal return metric that does reflect the real financing cost rate and real reinvestment rate?" In fact.08)4 + $55·(1. because A's IRR is further from the real reinvestmen rate than B's IRR. .

76. so the formula preceeds the Present Value sum with a "–" making it a poisitive number.76. 0. Note that IRR results show a larger advantage for Case A over Case B. for this particular example there is only one negative cash flow and because that occurs immediately ("Now") its present value shows 0 discounting effect. the projected incoming cash flows from investment B were reinvested at the reinvestment rate of 8. Case B has a MIRR of 14. The realtive investment advanage of A over B is much smaller with MIRR.06. the MIRR formula is really a geometric mean—exactly the same formula used to find comulative average growth rate§ for figures that grow exponentially. Incidentally. If B's initial cash outflow is simply put on deposit for 7 years. use the more precise MIRRA rate of 15. using a reinvestment rate of 8% and financing rate of 6%. at last. Note: To check these calculations yourself. However. is an investment result with a clear. In other words. whose cash flows are located in cells B3 through B10. which is 6% in this case. And.91.6732%. Internal rate of return compared to other financial metrics Referring to the example§ cases above. MIRR for Investment Case A is thus: Here.91. Or. 0.Present values of negative cash flows are also calculated using the financing rate.00) Negative cash outflows will have a negative present value. Or. if instead the projected cash inflows from the Investment Case A were reinvested at 8. However.06)0 = ($220. easily understood meaning: If the original $220 investment is simply put on deposit. which is the better business investment: Case A or . Excel's MIRR function would be: =MIRR(B3:B10. calculations like those above can be avoided entirely by simply using Excel's MIRR function. most people can easily compare MIRR results with compound interest growth and understand the magnitude of the MIRR difference. Similarly. As shown. the total investment value after 7 years would be the same $573. making these investments brings the same result as simply putting the investment costs in the bank and receiving interest at the MIRR rate. if instead. the total investment value with compound interest would be the same $587.0757% and MIRRB rate of 14.0%. the total investment value would be 573. Using the above formula.08). For Case A. PV (Negative CFs) = ($220)·(1. earning interest compounded at the MIRR rate. earning interest at the MIRR annual rate of 15. understanding the meaning of the IRR difference is more problematic.7%.1% for 7 years. the total value with compound interest would be $587.0%. such as compound interest earnings.

IRRs may play a role in answering such questions. NPV. ROI. This section compares A and B investmentson the basis of net cash flow. investor. As shown below. Net Cash Flow. IRR vs. First. A's inflows and outflows are much larger than B's. internal rate of return. whereas B's larger returns occur in later years. and payback period. A's large returns arrive early. It will take more than one financial metric to fully develop the implications of these differences. This difference is not apparent when viewing only the annual net cash flow figures. The prudent financial specialist. but generally. such questions should not be answered on the basis of a single financial metric.Case B? In many organizations. different metrics may suggest different answers to the question. and Payback period IRR results in the above examples required only the net cash flow figures for each investment each period. A actually brings in larger inflows but these come at larger costs. For more coverage of the individual metrics in this encyclopedia. Secondly. or business analyst will compare both investments with several financial metrics. however. In order to compare investments with a wider range of cash flow metrics. modified internal rate of return. return on investment. net present value. MIRR. Financial metrics results for Case A and Case B based on these data are as follows: . please follow the links provided with each metric. notice some of the most apparent differences between Case A and Case B cash flow. the analyst needs to see individual cash inflows and outflows as well as the net figures: Before looking at the individual metrics. as already noted.

1% to 14. see the discussion on Payback Period. The MIRR's meaning is easily understood: MIRR essentially compares investment results to the growth of compound interest earnings§. IRR. according to net present value§ depends on the discount rate.Total Net Cash Flow The net cash flow metric§ favors investment B over investment A: A brings a $200 net gain over 7 years. 15. the real rate of return difference between two different investments depends heavily on the timing of cash flows. IRR instead uses net cash flow figures themselves to find a rate that satisfies its definition. is sometimes seen as more "objective" because it does not rely on an arbitrarily chosen rate. as shown. and the actual rates available for cost of capital and reinvestment—none of which can be seen in the IRR figures. . this could be an important advantage for Case B. B's NPV of $155 exceeds A's $149 NPV. B's large returns in later years suffer greater discounting impact than A's larger returns in the early years. 30. the IRR figures themselves do not show the magnitude of A's real rate of return advantage over B. on the other hand. NPV leadership reverses at higher discount rates. This illustrates one reason some financial specialists prefer IRR to NPV when choosing between competing investments: NPV uses an arbitrarily chosen discount rate. A's NPV of $107 is higher than B's $91. below. 15. Internal Rate of Return (IRR) Investment A outscores Investment B on the IRR metric. investment A. Case B thus has a $40 (20%) advantage in net cash flow over A. With discounting at 10%. However. However.1%. which may determine results of the comparison. however. Return on Investment (ROI) According to the ROI metric. A's larger IRR can be taken as a signal that A provides a better rate of return than B (assuming that incoming cash flows are reinvested). or more.7%.6% to 20. the cash flow stream profiles. Modified Internal Rate of Return (MIRR) With an 8% real reinvestment rate. it's "no contest!" B's ROI of 52.7%.2% beats A's ROI of 18. When IRRs are several times larger than cost of capital. Both IRR figures are very likely above the company's cost of capital. Assuming that incoming returns are reinvested at 8%. As the discount rate rises. For situations where cash flow and working capital are problematic. for instance gives the investor exactly the same result as putting the initial cash outflow on deposit for seven years and receiving compound interest earnings at the MIRR annual rate. for a different view of these cash flow consequences. and both investments can thus be viewed as net gains. while B brings in $240. investment A slightly outscores investment B on theMIRR metric§.8%. Beyond that. Net Present Value (NPV) The better business decision—or preferred investment—A or B. At a 5% discount rate.

NPV. including ROI. Financial Metrics Conclusions When stating a decision criterion as a general rule. the investment (or action. Consequently. is sensitive to the magnitudes of individual annual inflows and annual outflows. The different financial metrics comparisons above illustrate the point that IRR is blind to many "other things" that may differentiate competing investments. Investors prefer payback periods that are shorter rather than longer for at least two reasons. Finally. In business investing—as in gambling—a wise investment (or a good gambling bet) is one where potential rewards compare favorably with investment risks. or if the appropriate discount rate for NPV rises because of risk considerations. B scores much higher on ROI because B has a larger incremental gain ($240) and a much smaller total cost ($460). these things may have important financial consequences. show both investments as net gains for the investor. no matter how large the returns. or scenario) with the higher IRR is the better business decision. business analysts and finance officers often borrow a phrase that is a favorite of economist: Other things being equal. A's larger total costs ($1. Payback Period The payback period metric§ shows that investment A "pays for itself" in 2. the investment funds are available again for re-use sooner with a shorter payback period.  A longer payback period is considered more risky than a shorter payback. and payback period:  An Investment with a high IRR can be viewed as less risky than a low IRR investment. the choice of one over the other represents so-called constrained financing. while it takes 3. ROI alone. as well as the . simply because of the longer time it takes to recover investment funds. investments with longer payback periods are considered more risky. This could be problematic because investment costs must be budgeted and paid for. and the investor may simply have trouble providing the larger funding costs. First. The other metrics derive only from the net cash flow figures. Interest rates for discounted cash flow include a "risk" component and an "inflation" component. the prudent investor will attempt to assess the likelihood that returns actually appear as projected.200) are compared directly to A's incremental gain of $200.0 years. the high IRR investment retains greater NPV than the lower IRR investment.hands down. If inflation rates rise during the investment period. The large difference in costs is "masked" or hidden in the other metrics.4 years for B's incoming gains to fully cover investment costs. sometimes called "cash on cash" analysis (incremental gains divided by investment costs§). All cash flow metrics above. When the investor can or will make only one of the two proposed investments. it is usually recommended that IRR not be used as a decision criterion when comparing competing mutually exlusive investments or actions. When using the above metrics as decision criteria. or decision. however. Second. and they are very rarely truly equal. None of the metrics above fully measures investment risk. The ROI metric shown here is Simple ROI. although risk considerations are partially visible in IRR. however.

or sometimes even the financial consequences of projects. i. the same value of i solves both equations. however. Yield to Maturity is the interest rate. they may be at a loss to interpret IRR message when one proposed action shows an IRR 10 or 20 times larger than a competing option.. project or program proposals. IRR is routinely calculated—or required—to support action proposals. Lease vs. This profile is common for some kinds of financial investments. that satisfies this version of the NPV equation: Bond Purchase Price = FV1 / (1+ i )1 + FV2 / (1+ i )2 + . Those who are called upon to provide IRR support for funding requests. Bond Purchase Price becomes the FV0 in the NPV equation that is used for IRR. 3 Do not use IRR when the net cash flow stream differs substantially from the investment curve profile (early net cash outflows. + FVn / (1 + i )n This definition for YTM can be changed into Definition 1 for IRR§. This is another reason that financial specialists use IRR as a metric for evaluating and comparing potential business investments. is that IRR (disguised under a different name) is used in evaluating bond investments§. This way. even when the investments are quite different in nature.. with only a slight difference in definition (for a more complete coverage of yield and other bond concepts. The situations described below illustrate the four "commandments" of IRR Usage.. IRR disgused as yield to maturity (YTM) for bond investing Another reason that IRR is a favorite metric for people trained in finance. + FVn / (1 + i )n Given the same cash inflows and outflows. or they find multiple IRRs for a single stream. The formula for IRR then asks for the same i that solves the equation: 0 = FV0 + FV1 / (1+ i )1 + FV2 / (1+ i )2 + . . and other actions. buy and other problem IRR results IRR can usually be found and usefully interpreted when based on net cash flow streams with the "investment curve" profile" shown above: Net cash outflows appear very early in the stream while net cash inflows follow through the rest of the investment life. later net cash inflows). Or. IRR and YTM are mathematically the same concept. simply by subtracting "Bond Purchase Price" from each side of the equation. The investment curve profile may also characterize some investments in income-producing assets. In many organizations.. product launches. programs. such as bond investments or bank deposits.liklihood that other beter and worse results appear. or business case analysis§ are often dismayed when they find that an IRR does not exist for their cash flow stream. even when expected cash flows do not fit the investment curve profile. If the IRR exercises above remind you of something you have seen before—solving an NPV equation for an interest rate—it is likely you are already familiar with the concept yield to maturity(YTM) used in bond investing. see the encyclopedia entry for bond§). or that there is a negative IRR.

which is sensitive to individual periodic cash inflows and outflows." 5 Do not be tempted to over interpret IRR magnitude and suggested return rates when IRR differs substantially from the real cost of capital and real reinvestment rates. . while MIRR for the Lease option is 99. the "Buy" option typically has a high initial cash outflow to buy the asset.0%. there should be cash inflows as the asset earns returns. In the remaining years of the asset's life. In brief.6%. using IRR as the sole decision criterion! In fact.  IRR looks only at the net cash flow figures each year. The two profiles difffer substantially from each other. IRR In a Lease vs." but the Lease option is better described as a 7-year commitment to a service contract with periodic fees. even if they are both roughly "investment curves.3% (basing MIRR on an 8% reinvestment rate. The leasing costs each year are "masked" or hidden from IRR by the larger positive inflows. Buy decision based on IRR would always choose leasing as the better business decision because IRR views the action as a financial investment. a Lease vs. Buy vs.5%. most people immediatelly ask: "What's wrong with this picture?" Here are three of the problems:  The Buy option is properly called an "investment. when results of this kind appear. The analyst who still insists on taking an "investment" view of both options should probably turn instead to the modified internal rate of return§. Buy comparison.400. Imagine choosing between these two options. The "Lease" option for the same asset starts with a very small initial cash outlay (if any). both options have exactly the same ROI.4 Do not use IRR to compare competing cash flow streams whose profiles differ substantially from each other. followed by almost the same net returns projected. The "Leasing" option has an IRR of 1. The Lease profile is not an investment curve. 226%  Both IRRs are certainly much higher than the company's real cost of capital and real reinvestment rates. 6 Do not even try to find an IRR when the net cash flow stream is entirely positive or entirely negative. The MIRR for the Buy option is 22. that is. These cash flow streams fit this pattern The "Buy" stream has an IRR of 42. There is no IRR for such situations. but reduced somewhat by the periodic leasing fees (this would be the case for a typicaloperating lease§). especially the Lease option IRR. When these options are compared with the Simple ROI metric (cash on cash§). Lease vs.

there may be real cash outflows in every period. As shown above. multiple. This signals simply that the investment or action should be considered a "net loss." Further quantitative analysis of negative IRRs is not advised. there is simply no mathematically correct IRR solution. that makes 2 sign changes.Impossible IRR: There is no possible IRR solution when the cash flow Includes only positive or only negative net cash flows. net cash flow event is negative. later. there will be no negative net cash flows. Other patterns of negative and positive net cash flows can also have no IRR solution. For other cash flow streams.However. and in the Lease vs. There will be one IRR for every sign change in the cash flow stream. other factors can be more important. tax consequences. or weighted average IRRs for multiple investments. Negative IRRs should certainly be diregarded when the analyst prepares IRR averages. and flexibility to upgrade or replace assets. Negative. There is no IRR in such cases. IRR can be blind to period leasing costs. If another. but when the inflows always outwiegh outflows. or multiple IRRs for the cash stream (more than one discount rate that leads to a 0 NPV). Buy decision.  Multiple IRRs: A net cash flow stream will have multiple IRRs when it Includes more than one sign change. as shown. that is one sign change and there will be one IRR for the stream. In such cases. and impossible IRRs  With certain cash flow streams it is mathematically possible to produce negative IRRs. When the first cash flow is negative and the second cash flow is positive. it is probably best to consider the IRR closest to the real cost of capital as the "true" IRR. Thanks: . such as the impact on the company's asset base.  Negative IRR: It is also possible for some net cash flow streams to produce a negative IRR value.