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Economics Interactive Tutorial

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

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.
In the future, at years 1 through 6, there will be net income of $200
each year.
All of the amounts in the income stream are net income, meaning
that each is income minus outgo, or revenue minus cost. In year 0,
the cost exceeds the revenue by $1000. In years 1 though 6, the
revenue will exceed the cost by $200.
This investment evidently has no salvage value. That is, there is
nothing that can be sold in year 6, the last year. If there were, the
amount that could be realized from the sale would be added to the
income amount for year 6.
For simplicity, all my examples have the incomes and outgoes at
one-year intervals. Real-life investments can have income and
expenses at irregular times, but the principles of evaluation are the
same.
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.
Each future income amount in the stream is discounted, 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. The opportunity cost can either be
how much you would have earned investing the money someplace
else, or how much interest you would have had to pay if you
borrowed money. See the interactive lecture on discounting future
income for more explanation. That tutorial has a niftyspreadsheet
setup for calculating present values that you can copy and use in
your own spreadsheet.
The word "net" in "net present value" indicates that our calculation
includes the initial costs as well as the subsequent profits. It also
reminds
us that all the amounts in the income stream are net profits,

revenues
minus cost. In other words, "net" means the same as "total" here.
The net present value of an investment tells you how this
investment compares either with your alternative investment or
with borrowing, whichever applies to you. A positive net present
value means this investment is better. A negative net present value
means your alternative investment, or not borrowing, is better.
Consider again this income stream:
Year

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. This makes the calculation simpler. With
this assumption, we can use the usual formula:
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, if the income amount is negative).
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. If we still assume that income comes or goes in annual
bursts and that the discount rate will be constant in the future,
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. The interest rate can vary, but that makes the
formulas messier. For example, if r1is the expected interest rate
next year, and r2 is the expected interest rate the year after that,
then the present value today of I2 income in year 2 is
I2/(1+r1)(1+r2).
The I 's are income amounts for each year. The subscripts (which
are also the exponents in the denominators) are the year numbers,

starting with 0, which is this year. The discount rate -- assumed to


be constant in the future -- is r. The number of years the
investment lasts is n.
Three properties of the net present value of an income stream are:
1. Higher income amounts make the net present value
higher. Lower income amounts make the net present value lower.
Try it yourself. Click on a box in the Income row. Edit the number there, deleting or
adding
some
digits.
Then
press
Enter.
The NPV box on the right shows the net present value, which is the total of the amounts in
the boxes in the Discounted row. (The total may be slightly off, due to rounding.)

2. If profits come sooner, the net present value is higher. If


profits come later, the net present value is lower.
Try it yourself. This applet lets you move the income amounts to later or earlier. You can
see how that changes the net present value of the income stream.

3. Changing the discount rate changes the net present value. For
an investment with the common pattern of having costs early and
profits later, a higher discount rate makes the net present value
smaller.
Try it yourself. Click on the discount rate box and change the number there. Then press
Enter.
You

can

also

change

the

income

amounts,

if

you

want.

To summarize what was just illustrated, the net present value is


higher if the income amounts are larger, or if they come sooner, or
if the discount rate is lower. The net present value is lower if the
income amounts are smaller, or if they come later, or if the
discount rate is higher.
Internal Rate of Return
In the example we've been using, if you keep the income amounts
at their original -1000, 200, 200, 200, 200, 200, and 200, and set
the discount rate to 0.0547, the net present value becomes
0. This discount rate, 0.0547 or 5.47%, is the internal rate of
return for this investment -- it is the discount rate that makes the
net present value equal 0. You can try this below, by setting the
discount
rate
to
0.0547.
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), you will
need a higher discount rate to bring the net present value back to

0. That would seem to imply that projects with higher incomes


have higher internal rates of return.
Similarly, if you lower any of the income amounts in years 1 through
6, then a lower discount rate will be needed to bring the net
present value back up to 0. That would seem to imply that
projects with lower incomes have lower internal rates of return.
These seeming implications are actually often true, if the projects
being compared have about the same shape, with the costs coming
early and the benefits coming late, and if the projects being
compared switch from net outgo to net income at about the same
time. Otherwise, though, the implications might not be true.
Before we go on to that, 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?
Please do not scroll down past this area until you have answered the
question.

The
resumes
here:

text

The internal rate of return does not require you to predict future
discount rates. That would seem to make the internal rate of return

the more useful (or less uncertain) measure. Sometimes, though,


the internal rate of return can fool you.
Contradictory Results
A few years ago, the New England Journal of Medicine published a
study that evaluated various types of professional education as if
they were financial investments.
The article is: Weeks, W.B., Wallace, A.E., Wallace, M.M., Welch,
H.G., "A Comparison of the Educational Costs and Incomes of
Physicians and Other Professionals," N Engl J Med, May 5,
1994, 330(18), pp. 1280-1286.
The idea was to see if doctors were overpaid, by considering
primary and specialty medical education as investments and
comparing them with investing in education in business, law, and
dentistry (but not university professors -- that would have been too
embarassing). Adjustments were made for differences in average
working hours. The authors found that primary medicine was the
poorest investment of all of these. Specialty medicine did better,
but was not out of line with the other professions.
In the results was this oddity: By the criterion of the net present
value of lifetime educational costs and income benefits, specialist
physicians tied for highest with attorneys. Both were ahead of
business school graduates. However, by the criterion of the
internal rate of return, specialty physicians, with a 21% average
return, were well behind the attorneys' 25% average return, while
the business school graduates' 29% average return was the highest
of all. The present value and the internal rate of return ranked
the alternatives differently!
By the way, since this article's 1994 publication, managed care has
forced specialty physician incomes down by perhaps onethird. This has sharply lowered the investment value of a
specialty medical education.
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, or NPV curve. The NPV
curve shows the relationship between the discount rate and the net
present value for a range of discount rates. The present value at
a given discount rate, such as 5%, and the internal rate of return
are each points on the NPV curve.

The NPV curve, the relationship between the discount rate and the
net present value has a formula that can be written like this:

This, of course, is the formula we saw already for the net present
value, for annualized costs and revenues and a constant discount
rate. Each I is an income amount for a specific year. The
subscripts (which are also the exponents in the denominators) are
the year numbers, starting with 0, which is this year. The
constant discount rate is r. The number of years the investment
lasts is n. In Weeks's study of professionals' incomes, n was about
44, because costs and incomes were calculated from age 21 to age
65.
We'll use an example with an n of 6, so the formula fits on your
screen:

This is our machine investment example that we have been using all
along. The NPV is a function of r. Graphed, it looks like this:

The blue curve shows the net present value for discount rates (r)
from 0 to 0.1 (0% to 10%). The red dots are the two points we get
from our measures. The left red dot shows the net present value
at the discount rate of 0.05 (5%). The right red dot shows the
internal rate of return, because it is where the curve crosses the
horizontal line indicating an NPV of 0. That right red dot is
between the 0.05 and 0.06 marks on ther axis, so the internal rate

of return is between 0.05 and 0.06. (The actual internal rate of


return is about 0.0547, as we saw earlier.)
Imagine we have another possible investment, which has this NPV
equation:

This investment is like the first, except that the net profit in years
1 through 6 is $220 per year, rather than $200. I would say that
this investment has a similar "shape" to the first, because the costs
and profits come at the same times. Also, the size of the initial
outlay is the same for both. The only difference is the amount of
profit. Here's a graph with both investments on it:

The green curve is the second investment. It is above and parallel


to the first investment's blue curve. The left orange dot shows the
net present value of the second investment at the discount rate of
0.05. The net present value there is a little over $100. This is
higher than the left red dot, 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 blue-line investment.
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. The internal rate of
return for the second investment is much higher (further to the
right).
In this example, our two measures, the net present value at r=0.05
and the internal rate of return, tell us the same thing. They both

say the second investment is better. A look at the graph above


confirms that the second investment is better at all discount rates,
so it is fair to say that the second investment is unequivocably
better than the first.
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. If your
discount rate is less than 5.47%, both NPV curves are in positive
territory, and you should do both, if you can.
Sometimes, though, the alternative investments are mutually
exclusive. For example, there may be two ways to build a dam
across a particular river. You can do one or the other, but not
both. There may be several alternative ways to address a
workplace safety problem. There is no point to doing more than
one if any one way solves the problem. Deciding on a professional
education involves somewhat mutually exclusive choices. A few
people do go to medical school and then law school, but the
additional return from the second degree is not the same as what
someone going to law school fresh out of college would expect.
If you can only do one investment, you should choose the one with
the highest net present value at the discount rate appropriate to
you. A problem with that advice, though, is that discount rates
can change with general economic conditions. 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. In our example so far, the greenline investment has a higher net present value at all discount rates,
so we would choose it with confidence. Regardless of what happens
in the future to discount rates, we'll be better off with the greenline investment than with the blue-line investment.
Can NPV Curves Cross?
Yes, they can. If the NPV curves cross, then the choice of
investment depends on the discount rate.
To create an example, I'll change the blue line investment so that
its profits come much later. This increases the effect of the
discount rate on the net present value. Below are the two income
streams, now. Also shown are their net present values at a 5%
discount rate and their internal rates of return.

Year

Green
line $220 $220 $220 $220 $220 $220
investment $1000
Blue
line $0
investment $1000
(modified)

$0

$0

$0

$0

NPV at Internal
0.05
rate of
discount return
rate
$117

0.086

$1550 $157

0.076

The green line invesment has the higher internal rate of return, but
the blue line investment has the higher net present value at a 5%
discount rate. Our two measures are giving us opposite advice!

The graph shows what's going on, by showing the Net Present Value
curves for both investments for discount rates between 0% and
10%. The curves cross at a discount rate of about 0.064, or 6.4%.
Now, to choose which investment we want to do, assuming we
cannot do both, we have to make a guess about what future
discount rates will be. If we expect discount rates to be less than
6.4%, where the curves cross, we choose the blue line
investment. For discount rates above 6.4%, but below 8.56% (the
internal rate of return of the green line investment -- the discount
rate at which the net present value of the green line investment is
$0), we choose the green line investment. At higher discount
rates than 8.56%, we don't do either, because the net present
values are below $0 for both investments.

If Costs Come Later Than Profits


If costs come later than profits, the NPV curve can tilt the other
way, making it even more problematic to use the internal rate of
return to compare investments.
Costs can come later than profits if an investment creates
environmental problems that will have to watched or cleaned up
later. Nuclear power plants are a good example. After about 40
years of service (sometimes less than that), they become too
contaminated with radiation to continue in service. They must
then be closed and either guarded where they are for thousands of
years or dismantled and moved to a disposal site.
Consider this income stream:
Year

Income amounts -$200 $200 $200 $200 $200 $200 -$900

I've reduced the initial cost, but added a big cost at the end. Let's
see what a difference this makes in how the NPV changes when the
discount rate changes. In the applet below, the starting discount
rate 5%. The net present value (NPV) is -$6. That's negative six
dollars, so if your discount rate really were 5%, you would not want
to do this investment.
Try changing the discount rate, by clicking in the discount rate box
and changing the 0.05 to something else. Try 0.04 or 0.03. In the
examples above, the NPV goes up when the discount rate is
lowered. Is that true for this project? Then try 0.06 or 0.07. What
happens
to
the
NPV?
(Keep the discount rates reasonably small, like between 0.00,
which is 0%, and 0.3, which is 30%.)
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, higher discount rates make the net present value
bigger, and lower discount rates make the net present value
smaller.
Before leaving the applet above, see if you can find the internal
rate of return, the discount rate that makes the net present value
equal to $0.

Here

is

the

NPV

graph:

The left blue dot shows the net present value at a 5% (0.05)
discount rate. It is at -$6 on the net present value scale.
The right blue dot is where the curve crosses the discount rate axis,
which is where the net present value is $0. The discount rate
here, 0.054 (5.4%), is the internal rate of return.
Or, at least, it fits the standard definition of internal rate of return.
However, unlike the usual situation, this project is profitable at
interest rates above this IRR and unprofitable at interest rates
below this IRR.
Suppose we have an alternative project which also has this shape,
with a big cost at the end, but slightly lower profits in the
intermediate years. I'll call the new alternative the "green line
investment."

Year

NPV
at Internal
0.05
rate
of
discount
return
rate

Red
line $200 $200 $200 $200 $200 -$6
investment $200
$900

0.054

Green
line $195 $195 $195 $195 $195 -$27
investment
$200
$900

0.070

The green line investment has a lower NPV than the red line
investment at all discount rates, because it has lower profits in
years 1 through 5, and the same costs in years 0 and 6. In
particular, as the table above indicates, it has a lower NPV at the
0.05 discount rate. The graph below shows the NPV curves for both

investments, with the green line lying below the red line at all
discount
rates.

The green line investment is clearly inferior, but it has the higher
internal rate of return. The green line investment's IRR is
0.07. The red line investment's is 0.054.
Thus, for projects with big late costs, the better projects will
have lower internal rates of return, the opposite of the rule for
normal projects that have their costs early and their positive
returns later.
Now let's discover something even more strange. Here's another
applet that lets you change the discount rate and see the effect on
the red line investment's value. This one, though, allows you to
take the discount rate over 0.3 (30%) and all the way up to 1.0
(100%). Those rates are much higher than, hopefully, we will ever
see in the U.S., but they are theoretically possible, and they show a
strange phenomenon.
Try raising the discount rate to 0.3, and notice what happens to the
net present value. Then, raise the discount rate some more above
that.
In which direction does the NPV move now?
See if you can find the second IRR, where the NPV is zero again!
Please do not scroll down past this area until you have answered the
question.

The
resumes
here:

text

Here's the NPV curve for the red line investment for discount rates
from
0%
to
100%.

At discount rates below 0.054, the NPV is negative, and this


investment
is
worse
than
doing
nothing.
At a discount rate of 0.054, the NPV is 0. The first IRR for this
investment
is
0.054.
If the discount rate rises above 0.054, the NPV turns positive, and
this
investment
switches
to
being
profitable.
At a discount rate of 0.262 (26.2%), the NPV for this investment
reaches its maximum. If the discount rate rises further than that,
the
NPV
falls.
The NPV reaches 0 again at a discount rate of 0.86. This is the
second
IRR
for
this
investment.
If the discount rate were rises even more, above 0.86, the NPV
turns negative again. This investment reswitches to being
unprofitable.
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, by itself, can fool you. If the investments you are
considering have different shapes (that is, very different timing of

costs and benefits) or if the project has large late cleanup costs,
then the higher-IRR-is-better rule can steer you to the wrong
investment. Ideally, you want the NPV curve, if you want to
evaluate an investment.
Additional notes
My use of the terms "switch" and "reswitch" refers to the
reswitching controversy of the 1960's. This was between economists
in Cambridge, England, and Cambridge, Massachusetts, over
whether capital markets can be analyzed just like other commodity
markets. The English economists, led by Joan Robinson, argued
that capital markets were special because of the possibility of
reswitching, which raises basic questions about the standard view
that the return to owning capital is a society's reward for abstaining
from consumption.
Some economists would say that only the second of our IRR's is the
true IRR, by defining the IRR as the place where the NPV is
0 and where the NPV is falling. The problems with that are: (1) this
distinction is usually lost in practice, and (2) by making the pattern
of costs and profits more complex, I can make up an investment
that has multiple discount rates where the NPV is 0 and the NPV is
declining.
The oldest discussion of this tutorial's issues that I have found in the
economics literature is Lorie JH, Savage LJ, "Three Problems in
Capital Rationing," Journal of Business, Vol. 28, October 1955.
That's all for now. Thanks for participating! Your comments would
be appreciated! Please e-mail me at sam@sambaker.com

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