When cash flows are ‘well-behaved’, then the Internal Rate of Return makes more or less sense, because you can argue that it is equivalent to the yield (interest rate) that a bond would pay to bondholders, and the cash flows are the (variable) coupons that you receive, and the Face Value of the bond is the cash flow you receive in the last year (at ‘exit’). Phew!
Let us take a look. In the ideal world, your cash flow stream might look like that, and the IRR is 15% in this case. In the last year, we have simply assumed that the business is sold at 5 times the cash flow generated in the previous year.
But let us assume that, for some reason, the cash flow is initial positive (for example because the project starts with a small-scale operation that is self-funded and financed by advisory services provided to customers; before ramping-up on a large scale, requiring significant investments). The cash flow below are otherwise the same as above, but delayed by 2 years, and with a different terminal value (higher multiple at exit). This project has 2 IRRs.
Which is the right one? None of them.
Note that the two IRR values of the project don’t have to be so far apart and could be closer, as in this cash flow stream below.
Check for yourself and download the following Excel file to run your own simulations.
Download “IRR calculation spreadsheet”IRR-calculations.xlsx – Downloaded 152877 times – 44.13 KB
Next time that someone asks you what the IRR of your project is, do ask him in return (if circumstances permit) to explain to you what the IRR is. You will be surprised! You might also answer that your project has multiple IRRs, and tell your audience that you are not sure whether it’s a good sign or not. See how people react.