## Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

of Health Administration, Economics Interactive Tutorials, last edited Dec. 5, 2009

Economics Interactive Tutorial

(Instructions)

**Perils of the Internal Rate of Return
**

Copyright © 2000 Samuel L. Baker The two most-used measures for evaluating an investment are the net present value and the internal rate of return. (Two earlier tutorials discussed these concepts. See the tutorials list for links to tutorials for discounting future income and the internal rate of return.) It is often assumed that higher is better for both of the net present value and the internal rate of return. In particular, it is usually stated that investments with higher internal rates of return are more profitable than investments with lower internal rates of return. However, this is not necessarily so. In some situations, an investment with a lower internal rate of return may be better, even judged on narrow financial grounds, than an investment with a higher internal rate of return. This interactive lecture explores why and when this reversal takes place. To review, both the net present value and the internal rate of return require the idea of an income stream, so let's start there. An income stream is a series of amounts of money. Each amount of money comes in or goes out at some specific time, either now or in the future. The income stream represents the investment; the income stream is all you need to know for financial evaluation purposes. In real life, individuals, charitable institutions, and even for-profit businesses have social or other goals when selecting investments. For businesses, the benefits of community good will are no less real for being difficult to measure precisely. For enterprises with social as well as financial goals, the measures discussed here are still useful: They tell you how much it costs you to advance your social goals. Here is an income stream example, from the interactive lecture about the internal rate of return. Year 0 1 2 3 4 5 6

Income amounts -$1000 $200 $200 $200 $200 $200 $200 Here we see seven points in time and, for each, a dollar inflow or outflow. At year 0 (now), the income amount is negative. Negative income is cost, or outgo. In this example, the negative income amount in year 0 represents the cost of buying and installing the machine.

but the principles of evaluation are the same. there is nothing that can be sold in year 6. we can use the usual formula: . revenues minus cost. or not borrowing. The net present value of an investment tells you how this investment compares either with your alternative investment or with borrowing. or how much interest you would have had to pay if you borrowed money. This makes the calculation simpler. A negative net present value means your alternative investment. In years 1 though 6. the last year. there will be net income of $200 each year. is better. the cost exceeds the revenue by $1000. meaning that each is income minus outgo. All of the amounts in the income stream are net income. In year 0. or revenue minus cost. That is. That tutorial has a nifty spreadsheet setup for calculating present values that you can copy and use in your own spreadsheet. In other words. "net" means the same as "total" here. The opportunity cost can either be how much you would have earned investing the money someplace else. With this assumption. For simplicity. It also reminds us that all the amounts in the income stream are net profits. the amount that could be realized from the sale would be added to the income amount for year 6.In the future. whichever applies to you. at years 1 through 6. If there were. Consider again this income stream: Year 0 1 2 3 4 5 6 Income amounts -$1000 $200 $200 $200 $200 $200 $200 Let's assume that the discount rate (the interest rate that you could earn elsewhere or at which you could borrow) will not change over the life of the project. See the interactive lecture on discounting future income for more explanation. the revenue will exceed the cost by $200. Real-life investments can have income and expenses at irregular times. meaning that it is divided by a number representing the opportunity cost of holding capital from now (year 0) until the year when income is received or the outgo is spent. Each future income amount in the stream is discounted. The word "net" in "net present value" indicates that our calculation includes the initial costs as well as the subsequent profits. A positive net present value means this investment is better. all my examples have the incomes and outgoes at one-year intervals. This investment evidently has no salvage value. Now let's discuss our two measures in connection with this income stream: Net Present Value The net present value of an income stream is the sum of the present values of the individual amounts in the income stream.

(The total may be slightly off. Three properties of the net present value of an income stream are: 1. deleting or adding some digits. For an investment with the common pattern of having costs early and profits later.Present Value of any one income amount = (Income amount) / ( (1 + Discount Rate) to the a power) a is the number of years into the future that the income amount will be received (or spent. The discount rate -. This applet lets you move the income amounts to later or earlier. Lower income amounts make the net present value lower. but that makes the formulas messier. if r1 is the expected interest rate next year. Try it yourself. a higher discount rate makes the net present value smaller. Then press Enter. which is the total of the amounts in the boxes in the Discounted row. the net present value is lower. Higher income amounts make the net present value higher. and r2 is the expected interest rate the year after that. For example.) 2. If profits come sooner. TheI 's are income amounts for each year. The NPV box on the right shows the net present value.assumed to be constant in the future -. 3. Then press Enter. if you want. The subscripts (which are also the exponents in the denominators) are the year numbers. The interest rate can vary. starting with 0. The net present value (NPV) of a whole income stream is the sum of these present values of the individual amounts in the income stream. Enable Java in your browser to see this applet. which is this year. Click on a box in the Income row. If we still assume that income comes or goes in annual bursts and that the discount rate will be constant in the future. . You can also change the income amounts.is r. due to rounding. Try it yourself. the net present value is higher. then the NPV has this formula: Varying future interest rates The future interest rate does not have to be constant for this theory to apply. Click on the discount rate box and change the number there. Try it yourself. then the present value today of I2 income in year 2 is I2/(1+r1)(1+r2). if the income amount is negative). Edit the number there. Changing the discount rate changes the net present value. If profits come later. The number of years the investment lasts is n. You can see how that changes the net present value of the income stream.

This discount rate. Before we go on to that. 200. by setting the discount rate to 0. the net present value is higher if the income amounts are larger. is the internal rate of return for this investment -. though. That would seem to imply that projects with lower incomes have lower internal rates of return.0547.0547. the implications might not be true. You can try this below. or if the discount rate is lower. or if the discount rate is higher.To summarize what was just illustrated. Similarly.47%. the internal rate of return can fool you. a little review: Which of these measures (net present value and internal rate of return) requires you to know the future income and outgo amounts? Which of the measures requires you to know what the discount rate will be in the future? The internal rate of return does not require you to predict future discount rates. Sometimes. if you keep the income amounts at their original 1000. or if they come later. 0. and if the projects being compared switch from net outgo to net income at about the same time.it is the discount rate that makes the net present value equal 0. and set the discount rate to 0. the net present value becomes 0. 200. and 200. or if they come sooner. Contradictory Results . you will need a higher discount rate to bring the net present value back to 0. then a lower discount rate will be needed to bring the net present value back up to 0. 200. The net present value is lower if the income amounts are smaller. 200. if you lower any of the income amounts in years 1 through 6. That would seem to imply that projects with higher incomes have higher internal rates of return.0547 or 5. 200. though. That would seem to make the internal rate of return the more useful (or less uncertain) measure. if the projects being compared have about the same shape. Internal Rate of Return In the example we've been using. If you now raise any of the income amounts in years 1 through 6 (feel free to edit an income amount and see for yourself). with the costs coming early and the benefits coming late. These seeming implications are actually often true. Otherwise.

. Specialty medicine did better. such as 5%.B.. the New England Journal of Medicine published a study that evaluated various types of professional education as if they were financial investments. Adjustments were made for differences in average working hours. by the criterion of the internal rate of return. were well behind the attorneys' 25% average return. 330(18). The constant discount rate is r. This has sharply lowered the investment value of a specialty medical education. A.. Both were ahead of business school graduates. Wallace. The authors found that primary medicine was the poorest investment of all of these. and dentistry (but not university professors -.that would have been too embarassing). In the results was this oddity: By the criterion of the net present value of lifetime educational costs and income benefits. The article is: Weeks.E. The number of years the investment lasts is n.M. M. The NPV curve. H.A few years ago. The idea was to see if doctors were overpaid. 1280-1286. Welch. with a 21% average return. or NPV curve. which is this year. of course. The present value at a given discount rate." N Engl J Med. The subscripts (which are also the exponents in the denominators) are the year numbers. and the internal rate of return are each points on the NPV curve. n was about 44. Each Iis an income amount for a specific year. specialist physicians tied for highest with attorneys. The NPV curve shows the relationship between the discount rate and the net present value for a range of discount rates. is the formula we saw already for the net present value. while the business school graduates' 29% average return was the highest of all. In Weeks's study of professionals' incomes. starting with 0. since this article's 1994 publication. law. However. Wallace... because costs and incomes were calculated from age 21 to age 65. The present value and the internal rate of return ranked the alternatives differently! By the way. the relationship between the discount rate and the net present value has a formula that can be written like this: This. managed care has forced specialty physician incomes down by perhaps one-third. 1994. "A Comparison of the Educational Costs and Incomes of Physicians and Other Professionals. pp. for annualized costs and revenues and a constant discount rate. W.G. The NPV Curve One way to understand how the net present value and the internal rate of return can give seemingly different advice is to use what I will call the net present value curve. but was not out of line with the other professions. May 5. by considering primary and specialty medical education as investments and comparing them with investing in education in business. specialty physicians.

That right red dot is between the 0. Also. as we saw earlier.06 marks on the r axis. The right red dot shows the internal rate of return.1 (0% to 10%). The left red dot shows the net present value at the discount rate of 0. The NPV is a function of r. because it is where the curve crosses the horizontal line indicating an NPV of 0. so the formula fits on your screen: This is our machine investment example that we have been using all along.0547.06. rather than $200. it looks like this: The blue curve shows the net present value for discount rates (r) from 0 to 0. I would say that this investment has a similar "shape" to the first. (The actual internal rate of return is about 0.We'll use an example with an n of 6. so the internal rate of return is between 0.05 (5%). The red dots are the two points we get from our measures. which has this NPV equation: This investment is like the first.) Imagine we have another possible investment. because the costs and profits come at the same times. the size of the initial outlay is the same for both. except that the net profit in years 1 through 6 is $220 per year.05 and 0. Graphed. Here's a graph with both investments on it: . The only difference is the amount of profit.05 and 0.

and you should do both. so the net present value at r=5% of the green-line investment is higher than the net present value at r=5% for the blueline investment.47%.05. the net present value at r=0. both NPV curves are in positive territory. though. the alternative investments are mutually exclusive. They both say the second investment is better. there may be two ways to build a dam across a particular river. our two measures. if you can. The internal rate of return for the second investment is much higher (further to the right). A look at the graph above confirms that the second investment is better at all discount rates. A few people do go to medical school and then law school. Deciding on a professional education involves somewhat mutually exclusive choices. Can You Do Both Investments? Doing an investment increases your wealth if its net present value is greater than 0 at the discount rate relevant to you. but the . There is no point to doing more than one if any one way solves the problem. so it is fair to say that the second investment is unequivocably better than the first. In this example. There may be several alternative ways to address a workplace safety problem. If your discount rate is less than 5. but not both. The right orange dot shows where the second investment's curve crosses the NPV=0 line. This is well to the right of the first investment's internal rate of return dot. You can do one or the other. Sometimes. The net present value there is a little over $100.The green curve is the second investment. This is higher than the left red dot. The left orange dot shows the net present value of the second investment at the discount rate of 0. tell us the same thing. It is above and parallel to the first investment's blue curve.05 and the internal rate of return. For example.

but the blue line investment has the higher net present value at a 5% discount rate. so we would choose it with confidence.additional return from the second degree is not the same as what someone going to law school fresh out of college would expect. You are therefore more confident about choosing one investment over another if your chosen investment has a higher net present value over a broad range of possible discount rates. A problem with that advice. then the choice of investment depends on the discount rate.$220 $220 $220 $220 $220 $1000 $1000 $0 $0 $0 $0 $220 $0 $1550 The green line invesment has the higher internal rate of return. Year 0 1 2 3 4 5 6 NPV at 0. they can. the green-line investment has a higher net present value at all discount rates. Can NPV Curves Cross? Yes. I'll change the blue line investment so that its profits come much later. you should choose the one with the highest net present value at the discount rate appropriate to you. now. If the NPV curves cross. though. To create an example. is that discount rates can change with general economic conditions.086 0. Below are the two income streams. If you can only do one investment.076 Green line investment Blue line investment (modified) . In our example so far. we'll be better off with the green-line investment than with the blue-line investment. This increases the effect of the discount rate on the net present value. Also shown are their net present values at a 5% discount rate and their internal rates of return. Regardless of what happens in the future to discount rates. Our two measures are giving us opposite advice! .05 discount rate $117 $157 Internal rate of return 0.

At higher discount rates than 8.The graph shows what's going on. or 6. by showing the Net Present Value curves for both investments for discount rates between 0% and 10%.4%. Costs can come later than profits if an investment creates environmental problems that will have to watched or cleaned up later.56%. If we expect discount rates to be less than 6. Consider this income stream: Year 0 1 2 3 4 5 6 . we choose the blue line investment. assuming we cannot do both. If Costs Come Later Than Profits If costs come later than profits. we have to make a guess about what future discount rates will be. the NPV curve can tilt the other way. but below 8. making it even more problematic to use the internal rate of return to compare investments.4%.064. because the net present values are below $0 for both investments. For discount rates above 6. we choose the green line investment.4%. where the curves cross.56% (the internal rate of return of the green line investment -. The curves cross at a discount rate of about 0. they become too contaminated with radiation to continue in service. After about 40 years of service (sometimes less than that).the discount rate at which the net present value of the green line investment is $0). we don't do either. Now. They must then be closed and either guarded where they are for thousands of years or dismantled and moved to a disposal site. to choose which investment we want to do. Nuclear power plants are a good example.

and 0. which is 0%. Before leaving the applet above. In the examples above. The net present value (NPV) is -$6. Try changing the discount rate. and lower discount rates make the net present value smaller. The right blue dot is where the curve crosses the discount rate axis. you would not want to do this investment. Try 0. is the internal rate of return.03. so if your discount rate really were 5%. Is that true for this project? Then try 0.Income amounts -$200 $200 $200 $200 $200 $200 -$900 I've reduced the initial cost. Let's see what a difference this makes in how the NPV changes when the discount rate changes.05) discount rate. which is 30%. see if you can find the internal rate of return. the discount rate that makes the net present value equal to $0. The discount rate here. the starting discount rate 5%.05 to something else. the NPV goes up when the discount rate is lowered. 0. like between 0. That's negative six dollars. .04 or 0. but added a big cost at the end. higher discount rates make the net present value bigger.00. What happens to the NPV? (Keep the discount rates reasonably small. In the applet below.3.06 or 0. by clicking in the discount rate box and changing the 0.) The relationship between the discount rate and the NPV is the reverse of what we see with "normal" investments! With this kind of income stream.4%). Here is the NPV graph: The left blue dot shows the net present value at a 5% (0. which is where the net present value is $0.054 (5. It is at -$6 on the net present value scale.07.

with a big cost at the end. because it has lower profits in years 1 through 5. The graph below shows the NPV curves for both investments. it fits the standard definition of internal rate of return.07. the opposite of the rule for normal projects that have their costs early and their positive returns later. at least. In particular. Thus. The green line investment is clearly inferior. and the same costs in years 0 and 6.Or. . it has a lower NPV at the 0. this project is profitable at interest rates above this IRR and unprofitable at interest rates below this IRR. unlike the usual situation. the better projects will have lower internal rates of return. The green line investment's IRR is 0.05 discount rate.$195 $195 $195 $195 $195 $200 $900 The green line investment has a lower NPV than the red line investment at all discount rates. However. Suppose we have an alternative project which also has this shape. but it has the higher internal rate of return.054.070 Red line investment Green line investment ." Year 0 1 2 3 4 5 6 NPV at 0. but slightly lower profits in the intermediate years. as the table above indicates. for projects with big late costs.05 discount rate -$6 -$27 Internal rate of return 0. The red line investment's is 0. I'll call the new alternative the "green line investment.$200 $200 $200 $200 $200 $200 $900 .054 0. with the green line lying below the red line at all discount rates.

though. and this investment switches to being profitable. At a discount rate of 0. hopefully.054.86.S. At a discount rate of 0. This is the second IRR for this investment.. very different timing of costs and benefits) or if the project has large late . allows you to take the discount rate over 0. where the NPV is zero again! Here's the NPV curve for the red line investment for discount rates from 0% to 100%. This one. Lesson: The NPV curve gives better guidance than the IRR alone The lesson I would like you to get from this is that the internal rate of return. Those rates are much higher than. This investment reswitches to being unprofitable. If the discount rate rises above 0. the NPV falls. and notice what happens to the net present value. and this investment is worse than doing nothing. and they show a strange phenomenon. If the discount rate rises further than that.Now let's discover something even more strange. but they are theoretically possible.054. If the investments you are considering have different shapes (that is. above 0. At discount rates below 0. we will ever see in the U.054. In which direction does the NPV move now? See if you can find the second IRR.262 (26. the NPV turns negative again. the NPV is negative. the NPV for this investment reaches its maximum. raise the discount rate some more above that. If the discount rate were rises even more.054. The first IRR for this investment is 0.0 (100%). Then. Here's another applet that lets you change the discount rate and see the effect on the red line investment's value. the NPV turns positive.2%).3 (30%) and all the way up to 1. by itself. Try raising the discount rate to 0. can fool you.3.86. the NPV is 0. The NPV reaches 0 again at a discount rate of 0.

sc. The English economists. . Savage LJ.edu http://hspm. led by Joan Robinson. Ideally.edu/Courses/Econ/Invest/invest. over whether capital markets can be analyzed just like other commodity markets. The oldest discussion of this tutorial's issues that I have found in the economics literature is Lorie JH. and Cambridge. you want the NPV curve. England. then the higher-IRR-is-better rule can steer you to the wrong investment.cleanup costs. Some economists would say that only the second of our IRR's is the true IRR. October 1955. and (2) by making the pattern of costs and profits more complex. by defining the IRR as the place where the NPV is 0 and where the NPV is falling. "Three Problems in Capital Rationing. The contents of this page have not been reviewed or approved by the University of South Carolina. argued that capital markets were special because of the possibility of reswitching. Vol. That's all for now.sph. which raises basic questions about the standard view that the return to owning capital is a society's reward for abstaining from consumption.html The views and opinions expressed in this page are strictly those of the page author. Massachusetts.baker@sc. This was between economists in Cambridge. Thanks for participating! Your comments would be appreciated! Email: sam. if you want to evaluate an investment. 28. I can make up an investment that has multiple discount rates where the NPV is 0 and the NPV is declining." Journal of Business. Additional notes My use of the terms "switch" and "reswitch" refers to the reswitching controversy of the 1960's. The problems with that are: (1) this distinction is usually lost in practice.

- Perils of the Internal Rate of Returnnathim
- Capital BudgetingZeeshan Ali Kaim Khani
- Financing Feasibility Analysis - Presentation (1)Sumit Verma
- Capital Budgeting Quizbahilog
- Financial Appraisalajityadav1987
- 5242606 Mit 3 Tools for Project Evaluationantoniobh
- Rupa Mathematics and Decision MakingPrashanna Pandey
- 2_The Time Value of Money_FSBrandy Newman
- NPV AND IRRChikwason Sarcozy Mwanza
- Capital Budgeting of Canteen WalaAmit
- Thermalnet Methodology Guideline on Techno Economic Assessmentskywalk189
- Economics Interactive Tutorialrbnkirui
- Investment Appraisal AccurateZachary Haddock
- Capital budgetingMunish Mahajan
- 1 - 5 units orgSuchitra Chandrasekar
- eyteam3 - phase h - closingapi-291817707
- Cap BudgetingTavishi Gurnani
- Project Management Professional (PMP)_General_Part Iguava58
- week12 IRR (1).pptAbidah Zulkifli
- Fin650 Lecture 4-5Anik Islam
- Victoria Chemicals Part 5cesarvirata
- 10 Economicsmoxlinde
- NPV and IRRRezaCfc
- IBCN TE Whitepaper 200911kokoska85
- House of DeblewisShehryaar Ahmed
- Finished-product Assignment Sfm (New)Raja Naveed
- Phuket Beach Hotel Proforma for Final)Andrey Turovchik
- PMP formulasSuranjan Kumar Das
- MATD MathsMM Fakhrul Islam
- Assignment 1Daniel

- Overall Business Case (With Appendices) - 17Nov2016 (3)BernewsAdmin
- Accounting(IAS)/Series-3-2010(Code3902)Hein Linn Kyaw
- Management Accounting Level 3/series 4-2009Hein Linn Kyaw
- Management Accounting Level 3/Series 4 2008 (3024)Hein Linn Kyaw
- Advanced Business Calculation/Series-4-2007(Code3003)Hein Linn Kyaw
- Management Accounting/Series-4-2010(Code3024)Hein Linn Kyaw
- Management Accounting Level 3/series 2-2009Hein Linn Kyaw
- Home Affordable Modification Program – Program Update and Resolution of Active Trial ModificationsForeclosure Fraud
- Management Accounting Level 3/Series 2 2008 (Code 3024)Hein Linn Kyaw
- Making Home Affordable Summary of GuidelinesFOXBusiness.com
- Advanced Business Calculations/Series-4-2011(Code3003)Hein Linn Kyaw
- Management Accounting/Series-3-2007(Code3023)Hein Linn Kyaw
- Management Accounting/Series-3-2010(Code3024)Hein Linn Kyaw
- Advanced Business Calculations Level 3/Series 2 2008 (Code 3003)Hein Linn Kyaw
- UT Dallas Syllabus for fin6301.501 05s taught by Yexiao Xu (yexiaoxu)UT Dallas Provost's Technology Group
- Ernst and YoungThe Rebel
- Airport Redevelopment Project Financial Comparison ReportBernewsAdmin
- Economics of Climate Proofing at the Project Level: Two Pacific Case StudiesAsian Development Bank
- Downtown East Stadium Term SheetMinnesota Public Radio
- Management Accounting Level 3/Series 3 2008 (Code 3023)Hein Linn Kyaw
- NYU Furman Center's 421-a updatecrainsnewyork
- RFQ for New Orleans Public Belt Railroad OperatorKatherine Sayre
- Cost Benefit AnalysisMetro Los Angeles
- Rocky-Mountain-Power--Exhibit-RMP-SCH-4Genability
- Center for Immigration Studies -- Camarota Wall CostsBob Price
- AMI Press Release 3-12-2012Foreclosure Fraud
- Management Accounting/Series-3-2004(Code3023)Hein Linn Kyaw
- UT Dallas Syllabus for fin6301.002.11f taught by Yexiao Xu (yexiaoxu)UT Dallas Provost's Technology Group
- Management Accounting/Series-2-2004(Code3023)Hein Linn Kyaw
- 67302_1995-1999FRASER: Federal Reserve Archive

- Private Equity at Work: Buying High When Financial Markets Are Flying High May Mean Disappointing ReturnsCenter for Economic and Policy Research
- Study: The Impact of Gulf of Mexico Deepwater Permit Delays on U.S. Oil and Natural Gas Production, Investment and Government RevenueEnergy Tomorrow
- nycirc_1992_10565.pdfFRASER: Federal Reserve Archive
- Management Accounting/Series-2-2011(Code3024)Hein Linn Kyaw
- fedres_advisory_20100106.pdfFRASER: Federal Reserve Archive
- Carlyle March 2013zerohedge
- Management Accounting Level 3/Series 2 2008 (Code 3024)Hein Linn Kyaw
- Priv Equity PerformanceFortune
- 20110228FundPerformanceActive (2)Fortune
- Utimco ActiveFortune
- Management Accounting/Series-3-2010(Code3024)Hein Linn Kyaw
- Are Lower Private Equity Returns the New Normal?Center for Economic and Policy Research
- pe_irr_06_30_15Fortune
- Advisory on Interest Rate Risk Management Januaryzerohedge
- Cc f Disclosure 050911Pando Daily
- Management Accounting/Series-4-2007(Code3023)Hein Linn Kyaw
- Cals TrsFortune
- nullM-NCPPC
- Economics of Climate Proofing at the Project Level: Two Pacific Case StudiesAsian Development Bank
- Management Accounting Level 3/Series 3 2008 (Code 3023)Hein Linn Kyaw
- NYU Furman Center's 421-a updatecrainsnewyork
- UTIMCO_PrivateMarketsFortune
- Venture Capital Funds Investing in Minority-Owned Businesses : Evaluating Performance and StrategyThe Ewing Marion Kauffman Foundation
- Calsterszerohedge
- UT Dallas Syllabus for ba3341.004 05f taught by Larry Merville (merville)UT Dallas Provost's Technology Group
- Active Trading Attestation ReportTheBusinessInsider
- Minorities and Venture Capital: A New Wave in American BusinessThe Ewing Marion Kauffman Foundation
- Cost Comparison Memo to PAC Oct 19, 2016(B)BernewsAdmin
- 885 Third Avenuezerohedge

Sign up to vote on this title

UsefulNot usefulClose Dialog## Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

Loading