Another dark side of IRR - Excessive leverage, increased default risk

and wealth destruction

Alexander Lahmanna , Maximilian Schreitera,∗, Bernhard Schwetzlera

a HHL Leipzig Graduate School of Management, Jahnallee 59, 04109 Leipzig, Germany

Abstract
The internal rate of return (IRR) is still a widespread criterion for investment decisions, although many
pitfalls are well known. This paper provides evidence for another, more fundamental, dark side of IRR:
Based on a dynamic model of optimal capital structure with endogenous bankruptcy trigger and risk-
adjusted yield of debt we show that capital structures maximizing IRR are suboptimal, i.e., not value
maximizing. The IRR criterion triggers the choice of higher leverage increasing the risk of default. De-
pending on the parameter setting the net benefit of financing reduces by up to 50 per cent. As optimizing
the financing structure based on IRR is popular in PE related settings, our results are especially important
for this industry.
Keywords: NPV, IRR, Default Risk, Optimal Capital Structure
JEL classification: G12, G31, G32, G33

∗ Corresponding author. Email: maximilian.schreiter@hhl.de.

Preprint submitted to Elsevier June 14, 2016

Electronic copy available at: http://ssrn.com/abstract=2795450

1. Introduction

The internal rate of return (IRR) reflects the discount rate making the net present value (NPV) of
an investment’s cash flow stream equal to zero. Many pitfalls of applying the IRR are well-known for
decades and represent a standard chapter in graduate textbooks on financial economics: Implicit assump-
tions about the reinvestment rate may lead to value-destroying investment choices, fading out absolute
present values may yield wrong rank-orders for mutually-exclusive projects, multiple or non-existent
IRRs may make it impossible at all to be used as decision criterion (see for instance Brealey et al., 2011,
for an overview).
Despite the academic critique, many investment and financing decisions in practice are still based
on IRR with the remark that the mentioned pitfalls only exist in specific setups and can be controlled.
Graham and Harvey (2001) find 75.7% of CFOs in their survey to rely on IRR for capital budgeting
decisions. Within the private equity (PE) industry the IRR is even more prevalent: Gompers et al. (2015)
report that 92.7% of PE investors use the IRR as a key parameter to value their equity investments and,
compared to other decision criteria, rank it first in importance. Also well-known advisors like Deloitte
(2015) or EY (2015) officially apply the IRR to determine the success of investments.
Textbooks on project finance and PE confirm practitioners by describing the Equity IRR, the discount
rate at which the initial equity investment equals the present value of future equity cash flows, as "the
most usual measure used by Sponsors and other investors to determine whether a project investment is
viable" (Yescombe, 2013, p. 314). Even more alarming is the growing use of the Equity IRR as a key
metric in academic publications. Kaplan and Schoar (2005), Nikoskelainen and Wright (2007), Valkama
et al. (2013) and Achleitner and Figge (2014) apply the Equity IRR as a performance measure to derive
success factors in PE investments.
As illustrated by Rosenbaum and Pearl (2009) in an LBO case study and empirically proven by
Valkama et al. (2013), the Equity IRR is severely influenced by capital structure decisions. Increasing
leverage triggers higher Equity IRRs while the Enterprise IRR is not significantly affected. The correla-
tion between the two measures "is only 0.64 (significant at the 1%level), which shows the significance of
the variation between these two" (Valkama et al., 2013, p. 2382).
While authors usually list the general drawbacks of IRR and claim that it should still be used be-
cause of its intuitiveness (see for instance Gatti, 2012; Viebig et al., 2008), they have never discussed the
particular implications of applying the Equity IRR.
To address this issues, we develop a dynamic structural model which allows for an integrated analysis
of firm values and optimal capital structures (such as Leland, 1994; Goldstein et al., 2001). In particular,
this is an EBIT-based, infinite time horizon model where equityholders maximize one of the classic
decision criteria, NPV or IRR, by endogenously choosing a static debt level and the optimal default
level. Such a simplified setting allows us to focus on the effects of the investment decision criteria upon
optimal capital structure choices, and avoids mixing up our results with other issues such as the optimal
redemption policy or maturity structure. Our model is based on a barrier options technique where the
stochastic EBIT-process represents the underlying while the lower barrier is defined by the optimal default
trigger.
As a result, we obtain another, fundamental, detriment of IRR: Capital structures maximizing the
Equity IRR are not value maximizing but reduce investors’ wealth. Moreover, investors led by the Equity
IRR criterion always choose higher levels of debt (leverage) and, thus, increase the default risk signifi-
cantly. The NPV-maximizing version of the model arrives at results similar to Leland (1994).
The remainder of the article is structured as follows. Section 2 introduces our basic model setting.
Subsequently, we develop the optimal capital structure choices for maximizing the NPV (Section 3) and
the IRR (Section 4). In Section 5 we present a formal proof of the IRR’s additional detriment followed
by a numerical application illustrating the severeness of our findings. Section 6 concludes the analysis.

Electronic copy available at: http://ssrn.com/abstract=2795450

2. Model setting

2.1. Unlevered asset value

We employ a standard contingent claims framework as used in theoretical corporate finance literature
(e.g., Leland, 1994; Goldstein et al. (2001); Titman and Tsyplakov, 2007). The unlevered asset (or firm)
value of an arbitrary firm depends on the operating income generated by a project with an infinite lifetime,
i.e., an EBIT-generating machine. We follow the classic Modigliani-Miller assumption that the EBIT is
invariant to changes of the project’s capital structure. The EBIT, X, is modelled by a geometric Brownian
motion under the risk-neutral probability measure Q

dX = µXdt + σXdW Q , t ≥ 0, X0 := X(0), (2.1)

where the mean appreciation rate µ under Q and the volatility σ > 0 are constants and W Q is a standard
Brownian motion defined on a filtered probability space (Ω, F , Q, (Ft )t≥0 )).1 For ease of computation, we
assume a constant risk-free rate r at which investors may invest and borrow money freely. The marginal
corporate tax rate, τ, is constant and deterministic.
Following these assumptions, the unlevered asset value with a current EBIT of X0 is given by
 ∞ 
Z
X0

Q
V(X0 ) = E0  (1 − τ)X s e ds = (1 − τ)
−rs 
, (2.2)

  r−µ
0

where EQ0 [.] denotes the conditional expected value operator under Q contingent on the available infor-
mation at t = 0 and V(X0 ) the unlevered asset value.

2.2. Levered asset value

Subsequently, we introduce an otherwise identical firm that is partly financed with debt. In order to
raise the debt, a console bond promising an infinite stream of continuous, credit risk-adjusted coupon
payments, C, is issued to the debtholders. In case of a future default, the firm stops paying the coupon
and is taken over by the debtholders. Therefore, C remains constant as long as the firm is solvent. The
debtholders determine the market value of the debt D(V) taking the credit risk into account.2 Bankruptcy
will be triggered if the unlevered asset value hits a certain boundary H from above. H is the endogenously
chosen level of asset value maximizing the equity value.
In case of default, i.e., Vt ≤ H, a fraction α, with α ∈ [0, 1], of the unlevered asset value is lost due
to bankruptcy costs, BC. The debtholders take control of the firm, leaving them with an asset value of
(1 − α)H. In the opposite case, with V > H, the firm stays with the equity investors and no bankruptcy
costs occur, BC = 0. Given the infinite lifetime of the firm and the constant coupon payments C of
the console bond, the market value of the bankruptcy costs can be calculated as the market price of a
perpetual, down-and-in, cash-at-hit-or-nothing, single barrier option. This contingent claim has a payoff
of 1 in case the boundary, H, is hit and pays nothing when the underlying, V, stays above the boundary.
Couch et al. (2012) use a similar approach for valuing the tax shield under the assumption of risky debt
and potential default. We define the value of such an option as contingent value factor PH and use the
pricing formula derived by Rubinstein and Reiner (1992):
 H y
PH = , (2.3)
V

1 See e.g. Goldstein et al. (2001).

2 The details will be shown in section 3 below.

3
where
 r 
1 σ 2
σ 2
y= 2 ) + (µ − )2 + 2rσ2  .
 
(µ − (2.4)
σ 2 2

Given the bankruptcy costs from above, their market value is

 H y
BC(V) = αHPH = αH . (2.5)
V
According to the trade-off theory firms choose their (optimal) capital structure by weighing the
marginal disadvantages of debt, reflected here by the bankruptcy cost against the financial benefits of
debt, represented by the debt-related tax savings. As in Leland (1994), Goldstein et al. (2001), Titman
and Tsyplakov (2007), we assume that tax savings, τC, are incurred as long as the firm remains solvent.
In the case of default no tax savings are generated. In case the default boundary H is never hit, the tax
shield value is τC/r. In the default case the tax shield value is zero. Again using the barrier option, we
obtain the following tax shield value:

τC τC  H y ! τC
T S (V) = − PH = 1− . (2.6)
r r V r

By using the same rationale, we determine the market value of debt, D(V). In case the boundary H is
hit, coupon payments are discontinued and the debtholders receive the assets of the firm less bankruptcy
costs, i.e., (1 − α)H. Otherwise, the firm remains solvent and the debtholders obtain an infinite series
of coupons with value C/r. In this basic setup we assume a debt issue without any protective covenant.
Thus, the market value of debt is determined by

C  C   H y
D(V) = + (1 − α)H − . (2.7)
r r V
At the time of issuance, the market value of debt, D(V), equals the nominal face value of debt, F.
This condition ensures that there are no arbitrage opportunities and the bond is properly priced by the
markets reflecting the credit risk and the associated cost of bankruptcy. The relationships described allow
to endogenously determine the promised yield of debt, yD , by
C
yD = . (2.8)
F
2.3. Risk of default
For explicitly determining the default risk over time t for both investment criteria we introduce the
cumulative probability of touching the default barrier from above, cd(t). An explicit analytic solution to
this probability is well-known from barrier option pricing and for instance derived by Shreve (2004):

cdt,Q = Q {V(t) < H}

m − αt m + αt
! !
=N √ +e N
2αm
√ , (2.9)
t t

4
with
σ2
!
1
a= µ− , (2.10)
σ 2
1 H
m = ln . (2.11)
σ V
Equation (2.9) describes the probability under risk-neutrality with a risk-neutral drift, µ, captured in
parameter a. Switching from the risk-neutral drift to the real-world drift, µP , yields the cumulative default
probability, cd(t, P), under the real-world probability measure P.

3. NPV criterion

We compare the capital structure choices of equityholders maximizing either their NPV or IRR, and
start by examining the NPV criterion:

NPV(V) = −I0 + E(V). (3.1)

As our goal is to measure the net benefit of debt financing for the equityholders, we set the initial
equity investment, I0 , equal to the unlevered value of the firm, V, less face value of debt, F:

I0 = V − F. (3.2)

The second component required by the NPV is the market value of equity which we determine by:

E(V) = V + T S (V) − BC(V) − D(V). (3.3)

Substituting Equations (2.5), (2.6), and (2.7) leads to:

C  C   H y
E(V) = V − (1 − τ) + (1 − τ) − H . (3.4)
r r V
Equation (3.4) is equivalent to the classic result of Leland (1994) but applying a barrier option ap-
proach. Next, we derive the barrier H ∗ (NPV) that maximizes the equity value by differentiating Equation
(3.4) with respect to H:
C y
H ∗ (NPV) = (1 − τ) . (3.5)
r 1+y
We determine the capital structure maximizing the equity investors’ NPV, i.e., the optimal coupon
payment C ∗ (NPV), by differentiating Equation (3.1) with respect to C under the condition that Equation
(3.5) holds. By applying the classic Lagrange approach we arrive at:
!− 1y
r(1 + y) (1 − τ)yα
C (NPV) = V
∗
1+y+ . (3.6)
(1 − τ)y τ

The optimal endogenous barrier and the optimal capital structure of our model are in line with the
results of the dynamic trade-off models in the spirit of Leland (1994) maximizing the market value of
equity. We provide a detailed derivation of Equations (3.5) and (3.6) in Appendix A.

5
4. IRR criterion

Next, we look for the optimal capital structure maximizing the IRR of the invested equity. The IRR
is the discount rate forcing an NPV of zero. Thus, we set Equation (3.1) equal to zero and substitute the
risk-free rate, r, by the IRR. Note that I0 is independent of the IRR as both investment criteria shall start
from the same basis:

NPV(V, IRR) =! 0 = −I0 + V(IRR) + T S (IRR) − BC(IRR) − D(IRR)

H yIRR
!! 
X0 C C y
= −I0 + (1 − τ) − (1 − τ) + (1 − τ) 1− , (4.1)
IRR − µ IRR IRR 1+y V

where
 r 
1 σ2
σ2
= 2 ) + (µ − )2 + 2 IRR σ2  .
 
yIRR (µ − (4.2)
σ 2 2

We assume the default boundary H to remain at H ∗ (NPV) as derived in Equation (3.5). The reason is
that the debtholders file for bankruptcy at this point, because they calibrate the promised yield, yD , based
on the default boundary of the wealth maximizing investor. As it is not observable for them whether the
equity investor applies NPV or IRR, they ask for the same promised yield in both cases and liquidate the
company at H ∗ (NPV). Otherwise, they face a negative NPV themselves.3
Since an analytic solution to Equation (4.1) does not exist, we numerically calculate the IRR-
maximizing coupon payments, C ∗ (IRR). Appendix B details our target function and the required con-
straints.

5. A fundamental detriment of IRR: Excessive leverage, increased default risk and wealth destruc-
tion

When analyzing the model outputs for both investment criteria, we find that IRR-maximizing in-
vestors always choose higher levels of debt triggering increased default risk and material wealth destruc-
tion. This is caused by an overestimation of the net benefits of debt, which we formally state and prove
in Theorem 1.
Theorem 1. Investors maximizing the internal rate of return (IRR) strictly overestimate the net benefits
of debt, if IRR > r:

NB(V, IRR) < NB(V, r)

F + T S (V, r) − BC(V, r) − D(V, r) < F + T S (V, IRR) − BC(V, IRR) − D(V, IRR). (5.1)

Proof. On an arbitrage-free market the face value of debt, F, equals the market value of debt in t = 0,
D(V, r). Thus, Equation (5.1) collapses to:

T S (V, r) − BC(V, r) <! F + T S (V, IRR) − BC(V, IRR) − D(V, IRR). (5.2)

3 We also modeled the case where the IRR-maximizing equity investors set a new optimal H ∗ (IRR) paying an individually
negotiated yD in order to fulfill the condition F = D(V). Such a scenario is conceivable for bank debt. The resulting optimal
leverage for IRR-maximizing equity investors increases even further, generating a higher default risk and a higher wealth
destruction.

6
 Substituting Equations (2.5), (2.6), (2.7) and (3.5) for both, IRR and r, gives:

τC  H y ! C y  H y ! τC  H yIRR ! C y  H yIRR
1− − α (1 − τ) <F+ 1− −α (1 − τ)
r V r 1+y V IRR V IRR 1+y V
C  H yIRR
! !
C C y
− + (1 − α) (1 − τ) − .
IRR IRR 1 + y IRR V
(5.3)

We replace F by D(V, r) as F = D(V, r), divide by C, multiply by IRR and summarize to:

IRR  H y y
!!  H yIRR y
!
τ−1− τ − 1 + (1 − τ) <! τ − 1 − τ − 1 + (1 − τ) . (5.4)
r V 1+y V 1+y

After changing signs, we simplify to:

  yIRR  y

IRR ! (1 − τ) 1 − V
H
1− 1+y
>   yIRR  y
 , (5.5)
r (1 − τ) 1 − HV 1− 1+y

where (1 − τ) cancels out. For ease of notation we define p = H/V, with 0 ≤ p < 1, and k = 1 − y/(1 + y),
with 0 ≤ k < 1. Subsequently, we bring Equation (5.5) to the following form:
IRR  IRR 
− 1 >! py − pyIRR k
r r
IRR  IRR 
− 1 >! − pyIRR −y kpy . (5.6)
r r
The left-hand side of Equation (5.6) is always positive as IRR > r. The right-hand side changes with
p = H/V on the interval [0, 1). For p → 1, we find:
IRR  IRR   IRR 
− 1 > lim − pyIRR −y kpy = − 1 k, (5.7)
r p→1 r r
which always holds trueas 0 ≤ k < 1.
Thus, showing that IRR r − p
yIRR −y
kpy is monotonically increasing for 0 ≤ p < 1, proves Equation
(5.6). We evaluate the first derivative and examine whether it is positive:
  
δ IRR r − p
yIRR −y
kpy IRR
= kypy−1 − kyIRR pyIRR −1 >! 0
δp r
IRR y
− pyIRR −y >! 0. (5.8)
r yIRR
IRR y
As pyIRR −y is strictly smaller than one, we only need to show that r yIRR > 1 to finally prove Theorem
1:
IRR y
>! 1
r yIRR
1  √  1  √ 
IRR 2 a + a2 + 2rσ2 >! r 2 a + a2 + 2IRRσ2
σ σ
√ √
IRR a + 2rσ − r a + 2IRRσ > a(r − IRR),
2 2 2 2 !
(5.9)

7
with a = µ − 12 σ2 .
Squaring Equation (5.9) and summarizing the terms yield:
√ √
a2 + σ2 (IRR − r) >! a2 + 2rσ2 a2 + 2IRRσ2 . (5.10)

Equation (5.10) allows us to eliminate the square roots by squaring a second time resulting in:

IRR2 + 2rIRR + r2 >! 4rIRR

(IRR − r)2 > 0. (5.11)

The left-hand side of Equation (5.11) is always positive as IRR > r which concludes the proof. 
A numerical application illustrates the finding and its implications. Using Equations (2.2), (2.3), (3.1),
(3.4), (3.5) and (4.1), we plot the NPV, the IRR, the levered firm value, the promised yield of debt and the
contingent value factor dependent on the debt level for a numerical example in Figure 1. We summarize
the chosen parameters in Table 1.

Table 1: Base case parameters of numerical application.

Parameter Description Value

X0 earnings before interests and taxes in t=0 10
µ risk-neutral drift rate of EBIT 0.00
σ volatility of EBIT 0.25
r risk-free rate 0.03
τ corporate tax rate 0.30
α bankruptcy cost ratio 0.30

The optimal debt level under IRR-maximization, D∗ (IRR) = 194.27, is 18.4 per cent higher than
under NPV-maximization, D∗ (NPV) = 164.10. The debt levels translate into leverage ratios, L = D/V L ,
of 74.5 per cent versus 62.1 per cent, respectively. The net benefit (or NPV) under IRR-maximization
reduces from 30.98 to 27.40 (−11.6 per cent), and the contingent value factor indicating the default risk
increases from 0.50 to 0.60.

8
 Debt Level D(V) Debt Level D(V)
0 40 80 120 160 200 240 0 40 80 120 160 200 240
40 0.8
30 0.6
NPV

PH
20 0.4
10 D*(NPV) 0.2 D*(NPV)
D*(IRR) D*(IRR)
0 0

0.06 0.08
0.05 0.06
IRR

yD
0.04 0.04
0.03 D*(NPV) 0.02 D*(NPV)
D*(IRR) D*(IRR)
0.02 0
0 40 80 120 160 200 240 0 40 80 120 160 200 240
300
280
260
VL

240
D*(NPV)
220 D*(IRR)
200
0 40 80 120 160 200 240

Figure 1: Net present value (NPV), internal rate of return (IRR), value of levered firm (V L ), contingent value factor (PH ) and
promised yield of debt (yD ) as function of debt value (D(V)). The two vertical lines in each graph represent the NPV-maximizing
debt value (blue, dotted line) and the IRR-maximizing debt value (red, dotted line).

Our results are robust for all sets of reasonable input parameters: The comparative statics in Table
2 show that the IRR-maximizing debt level is strictly higher than the NPV-maximizing debt level and
the net benefit is consistently reduced. We provide a graphical analysis of the parameter sensitivities in
Appendix C.

9
Table 2: Sensitivity analysis for NPV versus IRR with respect to all model parameters. In this ceteris paribus analysis we vary the
risk-neutral drift of EBIT (µ), volatility of EBIT (σ), risk-free rate (r), corporate tax rate (τ) and bankruptcy cost ratio (α). The table
depicts the impact on the optimal debt level (D∗ ) and the resulting net benefits (NB∗ ), values of levered firm (V L ), leverage ratios
(L∗ ) and contingent value factors (P∗H ) for both investment criteria, NPV and IRR.

Parameter 1 2 3 4 5 Parameter 1 2 3 4 5
µ -0.02 -0.01 0.00 0.01 0.02 σ 0.20 0.25 0.30 0.35 0.40
∗ ∗
D (NPV) 94.9 120.7 164.1 251.7 515.9 D (NPV) 172.2 164.1 158.2 153.8 150.4
D∗ (IRR) 123.8 151.2 194.3 280.4 543.1 D∗ (IRR) 204.2 194.3 186.6 180.6 175.8
NB∗ (NPV) 17.1 22.2 31.0 48.9 103.3 NB∗ (NPV) 34.5 31.0 28.4 26.5 25.1
NB∗ (IRR) 9.0 16.3 27.4 47.0 102.5 NB∗ (IRR) 29.6 27.4 25.7 24.3 23.3
V L,∗ (NPV) 157.1 197.2 264.3 398.9 803.3 V L,∗ (NPV) 267.9 264.3 261.8 259.9 258.5
V L,∗ (IRR) 149.0 191.3 260.7 397.0 802.5 V L,∗ (IRR) 262.9 260.7 259.0 257.7 256.6
L∗ (NPV) 0.60 0.61 0.62 0.63 0.64 L∗ (NPV) 0.64 0.62 0.60 0.59 0.58
L∗ (IRR) 0.83 0.79 0.75 0.71 0.68 L∗ (IRR) 0.78 0.75 0.72 0.70 0.69
P∗H (NPV) 0.56 0.53 0.50 0.46 0.42 P∗H (NPV) 0.42 0.50 0.56 0.62 0.67
P∗H (IRR) 0.75 0.68 0.60 0.52 0.45 P∗H (IRR) 0.55 0.60 0.65 0.69 0.73

r 0.01 0.02 0.03 0.04 0.05 τ 0.00 0.10 0.20 0.30 0.40
∗ ∗
D (NPV) 445.8 236.4 164.1 126.9 104.1 D (NPV) 0.0 96.6 144.2 164.1 172.1
D∗ (IRR) 519.6 278.6 194.3 150.5 123.4 D∗ (IRR) 0.0 108.9 169.8 194.3 199.0
NB∗ (NPV) 73.1 42.3 31.0 24.9 21.0 NB∗ (NPV) 0.0 4.7 16.4 31.0 47.0
NB∗ (IRR) 68.1 38.3 27.4 21.6 17.9 NB∗ (IRR) 0.0 4.7 15.4 27.4 39.1
V L,∗ (NPV) 773.1 392.3 264.3 199.9 161.0 V L,∗ (NPV) 333.3 304.7 283.1 264.3 247.0
V L,∗ (IRR) 768.1 388.3 260.7 196.6 157.9 V L,∗ (IRR) 333.3 304.7 282.0 260.7 239.1
L∗ (NPV) 0.58 0.60 0.62 0.63 0.65 L∗ (NPV) 0.00 0.32 0.51 0.62 0.70
L∗ (IRR) 0.68 0.72 0.75 0.77 0.78 L∗ (IRR) 0.00 0.36 0.60 0.75 0.83
P∗H (NPV) 0.70 0.57 0.50 0.44 0.41 P∗H (NPV) 0.00 0.31 0.43 0.50 0.53
P∗H (IRR) 0.75 0.66 0.60 0.57 0.54 P∗H (IRR) 0.00 0.34 0.50 0.60 0.67

α 0.10 0.20 0.30 0.40 0.50

∗
D (NPV) 198.1 180.0 164.1 150.2 138.0
D∗ (IRR) 232.3 214.7 194.3 176.2 160.5
NB∗ (NPV) 39.7 34.9 31.0 27.7 25.0
NB∗ (IRR) 32.9 29.1 27.4 25.3 23.3
V L,∗ (NPV) 273.1 268.3 264.3 261.0 258.3
V L,∗ (IRR) 266.2 262.4 260.7 258.7 256.6
L∗ (NPV) 0.73 0.67 0.62 0.58 0.53
L∗ (IRR) 0.87 0.82 0.75 0.68 0.63
P∗H (NPV) 0.57 0.53 0.50 0.46 0.43
P∗H (IRR) 0.73 0.67 0.60 0.55 0.51

Figure 2 depicts the cumulative default probability, cd, over time t for the IRR-maximizing capital
structure and the NPV-maximizing capital structure under the risk-neutral probability measure, Q, and
the real world probability measure, P. Considering the first ten years, the probability to default under
measure P increases by 9.7 percentage points (6.2 per cent versus 15.9 per cent) for investors applying
the IRR.

10
 1
0.9
0.8
0.7
cd(t, Q)

0.6
0.5
0.4
0.3
0.2
0.1

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
t

0.35
0.3
0.25
cd(t, P)

0.2
0.15
0.1
0.05

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
t

Figure 2: Risk-neutral and real-world default probabilities cumulated over time. The graph on the left depicts the risk-neutral
default probability, cd(t, Q), for the NPV-maximizing debt level, D∗ (NPV), (blue, solid line) and for the IRR-maximizing debt
level, D∗ (IRR) (red, dashed line). The graph on the right provides an exemplary translation in real-world probabilities, cd(t, P), with
a real-world drift of EBIT amounting to µP = 0.07.

Beyond the comparison of NPV criterion and IRR criterion, the analysis allows insights to the pa-
rameter’s comparative statics in general. For instance, a higher risk-neutral drift rate µ triggers higher
unlevered firm values V and increased optimal debt levels D∗ leading to higher firm values V L and im-
proved net benefits NB. All comparative statics are provided in Table 3.

11
Table 3: Comparative statics for all model parameters. The table depicts how a ceteris paribus increase of µ, σ, r, τ and α impact
the output variables of the model. The plus sign (+) represents an increase, the minus sign (−) reflects a reduction, and a zero sign
(0) stands for no impact.

Variable Change of Variable for Increase in:

µ σ r τ α
V(NPV) + 0 - - 0
V(IRR) + 0 0 - 0
D∗ (NPV) + - - + -
D∗ (IRR) + - - + -
NB∗ (NPV) + - - + -
NB∗ (IRR) + - - + -
V L,∗ (NPV) + - - - -
V L,∗ (IRR) + - - - -
L∗ (NPV) + - + + -
L∗ (IRR) - - + + -
P∗H (NPV) - + - + -
P∗H (IRR) - + - + -

6. Conclusion

In summary, our paper reveals a novel dark side of IRR when used in financing decisions: Maximizing
IRR systematically overvalues the net benefits of debt, thus yields a suboptimal capital structure which
reduces investors’ wealth and increases the firm’s default risk.

12
A. Appendix: Optimal choice of default barrier and capital structure under NPV-maximization

To determine the endogenous default trigger, H ∗ (NPV), that maximizes the equity value we start
from:
C  C   H y
E(V) = V − (1 − τ) + (1 − τ) − H , (A.1)
r r V
and differentiate with respect to H:

δE(V) ! C  H y−1 1  H y  H y−1 1

= 0 =! y (1 − τ) − − yH (A.2)
δH r V V V V V
! C 1
0 = y (1 − τ) − 1 − y (A.3)
r H
C y
H (NPV) = (1 − τ)
∗
. (A.4)
r 1+y
After some rearrangements we arrive at Equation (A.4) which is similar to Equation (3.5) from chapter 3.
Next, we derive the coupon payment, C ∗ NPV, which maximizes the investors’ NPV under the constraint
that the investors choose the optimal default barrier, H ∗ (NPV). Equations (A.5) and (A.6) represent the
approach formally:

NPV(V) = − I0 + V + T S (V) − BC(V) − D(V)

= − (V − D(V)) + V + T S (V) − BC(V) − D(V)
=T S (V) − BC(V)
τC  H y !  H y
= 1− − αH → max (A.5)
r V V

C y
s.t. (1 − τ) − H = 0. (A.6)
r 1+y
The described problem can be solved by the Lagrange method where we deduct the constraint from
the target function with a Lagrange multiplier λ. We differentiate the resulting Lagrange function with
respect to H and C. By setting the derivatives and the constraint equal to zero we have generated a
sufficiently defined equation system:

τC  H y !  H y !
C y
L= 1− − αH −λ (1 − τ) −H (A.7)
r V V r 1+y

δL τ  H y ! λ y
= 1− − (1 − τ) =! 0 (A.8)
δC r V r 1+y
δL τC  H y−1 1  H y  H y−1 1
= − y −α − αHy + λ =! 0 (A.9)
δH r V V V V V
C y
(1 − τ) − H =! 0. (A.10)
r 1+y

13
 Equations (A.9) and (A.10) can be rearranged for λ and H, respectively:
 H y  τC 
λ= y + α(1 + y) (A.11)
V rH
C y
H = (1 − τ) . (A.12)
r 1+y
Substituting Equations (A.11) and (A.12) into (A.8) yields:
!− 1y
r(1 + y) (1 − τ)yα
C ∗ (NPV) = V 1+y+ , (A.13)
(1 − τ)y τ

which is the NPV-maximizing coupon payment.

B. Appendix: Optimal choice of capital structure under IRR-maximization for given default bar-
rier

Equation (4.1) from chapter 4 is the starting point for finding the optimal coupon payment, C ∗ (IRR),
under IRR-criterion:

NPV(V, IRR) =! 0 = −I0 + V(IRR) + T S (IRR) − BC(IRR) − D(IRR)

H yIRR
!! 
X0 C C y
= −I0 + (1 − τ) − (1 − τ) + (1 − τ) 1− , (B.1)
IRR − µ IRR IRR 1+y V

where
 r 
(µ − σ ) + (µ − σ )2 + 2 IRR σ2  .
2 2
1
= 2
 
yIRR (B.2)
σ 2 2

While it is not possible to fully solve Equation (B.1) for IRR, there exists a work-around. Bringing I0
to the left-hand side, multiplying by IRR and dividing by I0 , generates Equation (B.3). This expression is
an IRR-function which we can maximize with respect to C but which still has the IRR on the right-hand
side. The introduction of Constraint (B.6) ensures that the model accounts for this fact. Moreover, we
have Constraint (B.4) for the default barrier and Constraint (B.5) for an arbitrage-free pricing of debt:

1 IRR X0 (1 − τ) y  H yIRR
! !
IRRmax = − (1 − τ)C + (1 − τ)C 1 −
I0 IRR − µ 1+y V
IRR X0 (1 − τ) y  H yIRR
! !
1
= − (1 − τ)C + (1 − τ)C 1 − → max (B.3)
V−F IRR − µ 1+y V

C y
s.t. (1 − τ) −H =0 (B.4)
r 1+y
C  C   H y
+ (1 − α)H − −F =0 (B.5)
r r V
IRRmax − IRR = 0 (B.6)

The resulting equation system cannot be solved analytically but by numerical methods, e.g. iteration.

14
C. Appendix: Sensitivity analysis

100

Leverage ratio (L* )

Net benefits (NB* )

0.8

50 0.7

0.6
0
−0.02 −0.01 0 0.01 0.02 −0.02 −0.01 0 0.01 0.02
Risk-neutral drift (µ) Risk-neutral drift (µ)
Contingent value factor (P*H )

Promised yield (yD )

0.7
0.07
0.6

0.5
0.05
0.4
−0.02 −0.01 0 0.01 0.02 −0.02 −0.01 0 0.01 0.02
Risk-neutral drift (µ) Risk-neutral drift (µ)

Figure 3: Sensitivity analysis for risk-neutral drift µ. Net benefits (NB∗ ), leverage ratio (L∗ ), contingent value factor (P∗H ) and
promised yield (yD ) are depicted as functions of the risk-neutral drift µ for NPV-maximizing capital structure (blue, solid line) and
IRR-maximizing capital structure (red, dashed line).

15
 35

Leverage ratio (L* )

Net benefits (NB* )
30 0.7

25
0.6

0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Volatility (σ) Volatility (σ)
Contingent value factor (P*H )

0.8 0.11

Promised yield (yD )

0.7 0.09

0.6
0.07
0.5
0.05
0.4
0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Volatility (σ) Volatility (σ)

Figure 4: Sensitivity analysis for volatility σ. Net benefits (NB∗ ), leverage ratio (L∗ ), contingent value factor (P∗H ) and promised
yield (yD ) are depicted as functions of the volatility σ for NPV-maximizing capital structure (blue, solid line) and IRR-maximizing
capital structure (red, dashed line).

16
 0.8

Leverage ratio (L* )

Net benefits (NB* )
60
0.7
40

0.6
20
0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05
Risk-free rate (r) Risk-free rate (r)
Contingent value factor (P*H )

0.09

Promised yield (yD )

0.7
0.07
0.6
0.05
0.5
0.03
0.4
0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05
Risk-free rate (r) Risk-free rate (r)

Figure 5: Sensitivity analysis for risk-free rate r. Net benefits (NB∗ ), leverage ratio (L∗ ), contingent value factor (P∗H ) and
promised yield (yD ) are depicted as functions of the risk-free rate r for NPV-maximizing capital structure (blue, solid line) and
IRR-maximizing capital structure (red, dashed line).

17
 0.8

Leverage ratio (L* )

Net benefits (NB* ) 40
0.6

20 0.4

0.2

0 0
0 0.1 0.2 0.3 0.4 0 0.1 0.2 0.3 0.4
Corporate tax rate (τ) Corporate tax rate (τ)
Contingent value factor (P*H )

0.07

Promised yield (yD )

0.6

0.4
0.05
0.2

0 0.03
0 0.1 0.2 0.3 0.4 0 0.1 0.2 0.3 0.4
Corporate tax rate (τ) Corporate tax rate (τ)

Figure 6: Sensitivity analysis for corporate tax rate τ. Net benefits (NB∗ ), leverage ratio (L∗ ), contingent value factor (P∗H ) and
promised yield (yD ) are depicted as functions of the corporate tax rate τ for NPV-maximizing capital structure (blue, solid line) and
IRR-maximizing capital structure (red, dashed line).

18
 Leverage ratio (L* )
Net benefits (NB* ) 35 0.8

30 0.7

0.6
25

0.5
0.15 0.25 0.35 0.45 0.55 0.15 0.25 0.35 0.45 0.55
Bankruptcy cost ratio (α) Bankruptcy cost ratio (α)
Contingent value factor (P*H )

0.7

Promised yield (yD )

0.6

0.5
0.05
0.4
0.15 0.25 0.35 0.45 0.55 0.15 0.25 0.35 0.45 0.55
Bankruptcy cost ratio (α) Bankruptcy cost ratio (α)

Figure 7: Sensitivity analysis for bankruptcy cost ratio α. Net benefits (NB∗ ), leverage ratio (L∗ ), contingent value factor (P∗H ) and
promised yield (yD ) are depicted as functions of the bankruptcy cost ratio α for NPV-maximizing capital structure (blue, solid line)
and IRR-maximizing capital structure (red, dashed line).

19
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