I recently had a conversation with an investor that was relying on their internal rate of return when considering an investment.
While I find the IRR to be a weak tool in general, the most pressing concern during this conversation was the reinvestment rate assumption that is embedded in the internal rate of return calculation.
The Problem With Taking The Internal Rate Of Return At Face Value
The investor produced a spread to me and, with the utmost certainty, stated that the internal rate of return on the parcel was over 19% and that since this was greater than what his return in the stock market was last year this was a better move.
What is the problem with such a comparison?
Not only is there a time span problem but the reinvestment rate assumption embedded in the internal rate of return calculation tend to inflate the IRR. In other words the 19% cannot be compared to a realized return in the stock market.
In plain terms if we calculated an IRR of 19% for a 5 year project the reinvestment rate assumption means that every cash flow received over the investment period is assumed to be reinvested at 19%.
To simplify, if we assume that the annual cash flows received are $1,000 for each of the 5 years this would mean that the IRR assumes that every one of those $1,000 cash flows received will be reinvested at 19%.
What is the problem with this? What is the likelihood that you can actually reinvest those cash flows at a rate of 19%?
Can you guarantee that when you receive the $1,000 in year 4 that you will be able to locate an investment at 19%?
We can’t even guarantee returns over a one year period yet when we use the IRR we are working off of an assumption that we will be able to reinvest cash flows over the length of a project at the calculated IRR.
To be clear if we were simply comparing two similar parcels with similar risk characteristics we can still use the IRR. This isn’t because I find it to be a good tool but instead because it at least ensures that you are comparing apples to apples so the assumptions are at least constant. . . .even if flawed.
The idea that I am trying to convey here is that the IRR is not foolproof and that it cannot just be compared with other returns because of the embedded assumptions.
The other point I am trying to convey is that an investor will never achieve the calculated internal rate of return unless they are able to reinvest all cash flows at the computed internal rate of return.
In the example above where the investor calculated an internal rate of return of 19% it is highly unlikely that he would have found 19% investments to reinvest cash flows in over the project life.
In the worst case if he found no other investment and held the cash flows in cash earning 0%, the 19% internal rate of return would be substantially reduced. In this particular example the rate dropped to 11%.
This is just one specific example of why it may not be possible to rely on any one metric and to have a fair understanding of whichever metric you decide to be superior.
Do you agree with me?
Be sure to leave your thoughts and comments below!