Three ways you’re being manipulated by IRR

Internal rate of return (IRR) is often confused with return on investment (ROI). Using IRR sounds impressive but in reality it has nothing to do with measuring the value of an investment.  In fact, it’s the most easily manipulated metric there is. If someone is using IRR to convince you to move forward with an investment, run, don’t walk away.  It’s likely you’re being scammed.

There are three ways someone can manipulate IRR to make it more favorable: time horizon, early assumptions, and difference between cost of capital and the calculated IRR.

Time horizon

The longer the timeframe the higher the IRR.  The calculation assumes a reinvestment rate at the same rate it calculates.  That means money received early in the period is assumed to be reinvested at the same rate.  Need a better IRR?  Just extend from say a 3-year timeframe to 5 years in the name of “conservatism” and watch the IRR go up.

Front load the benefits

Now that you know the time horizon trick you can use that to your advantage by front loading any benefits.  A minor increase in estimated early benefits can have a big impact on the calculation. You can even eliminate later benefits and still see a significant increase in IRR from those minor increases in early benefits.  Want a higher IRR?  Bump those early benefits up a tiny bit.

Real world example

Nucleus was completing an ROI case study on a project for a state government years ago that didn’t match the estimates they had calculated.  It turns out the very prominent consulting firm that pitched them on the project calculated IRR, not ROI, using a 9-year horizon with plenty of benefits in the first few years but practically none in later years to, as they apparently said, “be conservative.” Curiously, the IRR was just high enough to justify the project (and make a lot of money for that consulting firm, I’m sure). In reality? The actual ROI was negative.

Relationship between cost of capital and IRR

Because of the previously mentioned reinvestment assumption, the IRR calculation is more accurate the closer it is to the cost of capital.  The greater the difference between the two, the greater the false increase in the IRR against the actual value of the project.  Essentially, that means IRR is most accurate, when it’s close to the cost of capital.  But that tells you not to move forward with the project.

Modified Internal rate of return (MIRR) tries to fix some of these issues, but then we’re just trying to fix a problem that is solved with ROI.  Your best strategy?  Ignore IRR, and use ROI.