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The Engineering Economist TJ1099-06 May 27, 2004 18:21

The Engineering Economist, 49:185–197, 2004

Copyright

c Institute of Industrial Engineers
ISSN: 0013–791X print / 1547–2701 online
DOI: 10.1080/00137910490453437

TECHNICAL NOTE—THE INTERNAL RATE

OF RETURN (IRR) AS A FINANCIAL
INDICATOR

Miroslaw M. Hajdasinski
School of Engineering, Laurentian University,
Sudbury, Ontario, Canada

In their recent paper Tang and Tang (2003, pp. 69–78) revive a long-
standing controversy—net present value (NPV) versus internal rate of
return (IRR)—by characterizing the NPV as an economic indicator and
the IRR as a financial one. The paper implies that this distinction justifies
ranking financial alternatives by ranking their IRRs. In the current arti-
cle, it is argued that the direct IRR ranking does not necessarily provide
the same evaluation environment—and therefore a fair comparison—for
each alternative involved, and that the incremental ranking approach
is needed to remedy this shortcoming. The article also points out that
Tang and Tang’s numerical examples of simple projects with one sign
change in their cash flow patterns do not address the problem of multi-
ple IRRs, which consequently renders Tang and Tang’s ranking approach
dysfunctional. It is demonstrated that the concept of a true rate of return,
substituting for the non-performing IRR and applied in conjunction with
the incremental approach, provides an adequate tool for ranking mutually
exclusive projects or a project’s technical or financial alternatives.

In their recent paper, Tang and Tang (2003) join the decades-long
discussion on the merits and validity of the internal rate of return (IRR)
as a viable alternative to the net present value (NPV) project-evaluation
criterion. They argue that, notwithstanding the persistent criticism of the
IRR, which has been voiced primarily in academia (Brigham et al., 1994;
Hirshleifer, 1958; Rapp, 1980; Solomon, 1963), this criterion is still
sound and useful, provided that it is properly interpreted. To remedy the

Address correspondence to Miroslaw M. Hajdasinski, School of Engineering, Laurentian

University, 935 Ramsey Lake Road, Sudbury, Ontario, P3E 2C6, Canada. E-mail: mhajdasinski@
laurentian.ca

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186 M. M. Hajdasinski

perceived problem of the IRR and the NPV being inadequately defined,
Tang and Tang offer their own definitions of these two criteria. According
to them, the “IRR gives the private investor’s point of view and the NPV
the society’s point of view.”
However, regardless of the point of view, the mathematics of the
NPV/IRR relationship remains the same, and so do the well-documented
problems resulting from this relationship (Fisher, 1930; Fleischer, 1966;
Hirshleifer, 1958; Mao, 1966). In what follows, it is demonstrated, using
Tang and Tang’s and other numerical examples, that a direct comparison
of the IRRs of various project-financing alternatives for the purpose
of ranking is not a recommended approach. The proper approach will
be revisited, and the limitations of the IRR applicability will again be
emphasized.
The considerations will be conducted with the assumption of certainty
and a perfect capital market with identical investment and borrowing
rates referred to simply as the market interest rate MARR—minimum
attractive rate of return for investment projects, and maximum attrac-
tive rate of return for borrowing projects. In their paper, Tang and Tang
implicitly embrace this assumption by adopting the same interest rate
for calculating the NPV. Also, for the sake of consistency with the for-
mat used in the above-mentioned paper, an annual discrete time period,
annual cash flows (CFs), and annual discrete interest rates expressed in
percentages are assumed without any loss of generality of the ensuing
considerations.

COMPARING INCOMPARABLE FINANCING

ALTERNATIVES

In their numerical examples, Tang and Tang (2003, Table 1, p. 71)

compare three different alternatives of financing a project that is char-
acterized by the following CF pattern (CFP):

{−10,000; 5000; 5000; 5000}. (1)

This CFP reflects the first, and basic, project financing alternative (PFA),
where an investment of $10,000 is financed in full by the equity capital,
producing an IRR of 23.38%.
The second PFA considered is created by leveraging Project (1) with
a market borrowing project:

{6000; −2600; −2400; −2200}, (2)

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The Internal Rate of Return (IRR) as a Financial Indicator 187

which results in the following leveraged CFP (Tang & Tang, 2003,
Table 3, p. 72):

{−4000; 2400; 2600; 2800}. (3)

This CFP yields an IRR of 41.17%.

If Project (1) is market leveraged even further, by having $9,000 out
of the $10,000 investment, provided by the market borrowing project:
{9000; −3900; −3600; −3300}, the third PFA is created. It is defined
by the CFP

{−1000; 1100; 1400; 1700}, (4)

generating an IRR of 113.1%. While the IRRs of Projects (1), (3), and
(4) are increasing as the equity for project financing declines due to
financial leverage, the NPVs of all of these projects are identical, thus
indicating that all projects are equally attractive from the economic point
of view, as Tang and Tang refer to it.
Note, in this context, that a post-leverage CFP, like CFP (3), or (4), is
one that is composed by combining two individual projects: the original
unleveraged PFA (1) and a market borrowing project that reflects the ex-
ternal financing arrangements. The borrowing project’s NPV calculated
at the borrowing MARR is, by definition, equal to zero, since the market
interest rate of 10% used for discounting is the same as the rate of return
(ROR) of the borrowing project. As a result, the NPV of the combined
project, being the sum of the original, unleveraged CFP (1)’s NPV and
of the zero-NPV of the borrowing project, will always be identical with
the NPV of the original Project (1). This is true for any possible CFP of
the borrowing project (as any market borrowing project will, by defini-
tion, produce its NPV equal to 0), and is, therefore, evident without an
elaborate mathematical proof.
Notwithstanding the NPV identity of the three PFAs (1), (3), and (4),
Tang and Tang arrive at a conclusion, based on a direct comparison of the
three alternatives’ IRRs on equity, that the higher the degree of market
leverage in a PFA, the more desirable this alternative is from, again using
Tang and Tang’s terminology, the financial point of view.
However, when comparing two PFAs by means of the IRR, Tang and
Tang do not provide the same evaluation environment for both alter-
natives. For example, if PFA (1) were to be compared with PFA (3),
then it would obviously have to be assumed that the investor has the
necessary amount of $10,000 of equity that is required to finance the
alternative with the higher equity consumption—in this case, PFA (1).
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188 M. M. Hajdasinski

To guarantee a level playing field for the comparison of both financing

alternatives, the availability of that amount of equity should also be the
starting point for consideration of any external financing arrangements.
Consequently, instead of asking “Which PFA returns more on the equity
capital invested in that alternative alone?” the question becomes “Which
of the two financing alternatives provides a better overall return on the
same available equity capital, measured by that capital’s overall IRR?”
Accordingly, while in PFA (1) the entire equity of $10,000 is con-
sumed by the project, in PFA (3) $6,000 is borrowed from the market,
and only $4,000 out of the available equity of $10,000 is invested in the
project. This leaves an equity of $6,000 free for an additional investment
which—according to the initial assumptions—can only be made in the
market, earning the MARR = 10% as its IRR. As a result, the overall
return on total equity in PFA (3) will be some mean IRR value bracketed
by the two IRRs, 10% and 41.17%.
To find this IRR value, an assumption must now be made about the
pattern of market returns on the $6,000 equity investment. One non-
controversial assumption would be that the market returns on that invest-
ment are mirror images of the returns defined by borrowing Project (2),
where the same amount of $6,000 is borrowed from, rather than invested
in, the market. Adopting this assumption would produce a market in-
vestment project with the following CFP:

{−6000; 2600; 2400; 2200}, (5)

which is a mirror image of borrowing Project (2), and has the same
IRR of 10%. The case of a return pattern different from that defined by
investment Project (5) will be addressed in the next segment of this text.
Next, combining CFPs (3) and (5) yields a resultant CFP that is iden-
tical with CFP (1), thus producing the same IRR = 23.38%. As a con-
sequence, PFA (3) turns out to be IRR-equivalent with PFA (1), which
demonstrates that a direct comparison of two IRRs earned by the same
project on unequal equity investments may produce misleading results.
A similar conclusion would be reached if the same analysis were applied
to comparing PFA (1) with PFA (4), thus proving that, if $10,000 of eq-
uity is available, all three PFAs are equivalent—to use Tang and Tang’s
nomenclature and ranking approach—not only from the economic, but
also from the financial, point of view.
Further, if the investor did not have $10,000, but only $4,000 of eq-
uity capital available for the project, PFA (1) would become financially
infeasible, and therefore irrelevant, and only the feasible alternatives (3)
and (4) could be meaningfully compared. To rank them in the manner
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The Internal Rate of Return (IRR) as a Financial Indicator 189

demonstrated above will require market borrowing of $6,000 for PFA (3),
and of $9,000 for PFA (4). This would leave PFA (4) with $3,000 of free
equity that, if invested in the market, would produce a market investment
project:

{−3000; 1300; 1200; 1100}, (6)

according to the same scaled-down return-generation pattern that had

earlier produced the market investment Project (5).
And, combining CFPs (4) and (6), to find the overall IRR on the
$4,000, of equity results in a CFP that is identical with CFP (3), and
that, therefore, produces the same IRR of 41.17%. This leads again to
an NPV-consistent conclusion, that, if evaluated fairly, both alternatives
(3) and (4), are financially equivalent, and both yield an overall IRR of
41.17% on the $4,000 of equity capital.
Finally, if the investor had only $1,000 of equity capital available,
PFAs (1) and (3) would become financially infeasible, and the only
financially viable alternative remaining would be PFA (4), yielding an
IRR of 113.1% on the $1,000 equity investment.

RANKING BASED ON THE INCREMENTAL APPROACH

Generally, ranking project alternatives by ranking their IRRs is not

a good idea, as shown above in the example of PFAs (1), (3), and (4).
This was discovered more than seventy years ago by Fisher (1930) and
has subsequently been frequently reiterated by others (Fleischer, 1966;
Mao, 1966). Yet, the equivalency of the above-mentioned three PFAs
was demonstrated by comparing their identical IRRs generated on the
available equity, which seems to contradict the above statement. The
reason that it does not is that the CFPs that generated those identical
IRRs were also identical, which constitutes a very special case.
However, if the CFPs of the competing alternatives are not identical,
the only conceptually sound approach to their ranking by means of
the IRR is the incremental approach (Fisher, 1930; Fleischer, 1966;
Hajdasinski, 1997). This approach first identifies the generic differences
between two competing alternatives, A and B, exemplified by the
incremental CFPs (A-B), or (B-A), and then determines, using the
NPV, or an NPV-compatible profitability criterion of choice, which
project benefits from those differences. That project is then considered
dominant over its competitor.
To demonstrate the incremental approach, using the IRR as the eval-
uation criterion with Tang and Tang’s examples, consider first the PFAs
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190 M. M. Hajdasinski

defined by CFPs (1) and (3). The incremental CFP [(1)–(3)], exempli-
fying the difference between PFAs (1) and (3), turns out to be identical
with CFP (5). Since the IRR of this CFP is equal exactly to the MARR
= 10%, this indicates that neither of the two compared Projects, (1) and
(3), benefits from the hypothetical incremental project; hence, neither is
dominant over the other. Comparing now, in the same fashion, Projects
(1) and (4), an identical result is obtained, implying that Projects (1),
(3), and (4) are equivalent, thus confirming the NPV-based ranking.
The incremental approach can be applied to ranking mutually ex-
clusive alternatives of the same project or to ranking different mutually
exclusive projects. By evaluating the differences between two competing
projects, the incremental approach allows the comparison of projects, or
project alternatives, with different CFPs. A special class of such CFPs
are those having identical investments because, according to popular
belief, projects, or alternatives of projects, with such CFPs can be ranked
by directly ranking their IRRs.
To show that this belief is a misconception, let us revisit the com-
parison of PFAs (1) and (3), along with the complementary market in-
vestment of $6,000 of the equity that was earlier “liberated” through the
leverage of Project (1) and was assumed to produce CFP (5). However,
this assumption, although entirely legitimate, represented only one of
an infinite number of possible market return patterns. Let us consider
two additional, somewhat extreme, albeit possible, market investment
patterns reflected by the following CFPs (7) and (8):

{−6000; 0; 0; 7986} (7)

{−6000; 6600; 0; 0}. (8)

Combining each of these CFPs with CFP (3) results in the following
CFPs (9) and (10), respectively:

{−10,000; 2400; 2600; 10,786} (9)

producing an IRR of 20.23%, and

{−10,000; 9000; 2600; 2800}, (10)

yielding an IRR of 27.58%. All three CFPs, (1), (9), and (10), have an
identical investment of $10,000, and if the IRRs of CFPs (9) and (10)
were now to be directly compared with the IRR = 23.38% of CFP (1), this
would suggest that different market return patterns on the $6,000 market
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The Internal Rate of Return (IRR) as a Financial Indicator 191

investment can make PFA (3) either inferior to PFA (1), if the returns
are defined by CFP (7), or superior to it, if the returns are reflected by
CFP (8).
However, an application of the incremental approach shows that nei-
ther is true, as all three return patterns (5), (7), and (8) produce equivalent
CFPs (1), (9), and (10). Indeed, the incremental alternative reflecting the
difference between CFPs (1) and (9) is the borrowing project:

{0; 2600; 2400; −5786} (11)

with a borrowing IRR of 10% = MARR. A numerically identical in-

vestment IRR will be obtained from the incremental investment project:

{0; −4000; 2400; 2200} (12)

that defines the difference between CFPs (1) and (10).

Because both incremental Projects (11) and (12) produce an IRR
identical to the MARR, they imply the equivalence of Projects (1) and
(9) on the one hand, and of Projects (1) and (10) on the other. This means,
by implication, that Projects (9) and (10) are also financially equivalent.

INTERNAL RATE OF RETURN VERSUS TRUE RATE

OF RETURN1 (TRR)

The above-demonstrated “phenomenon” of three projects that are

equivalent by NPV standards, while yielding three different IRRs on the
same investment, can be explained by realizing that an IRR is, in fact,
not the ROR on the initial investment, but—as pointed out by Bernhard
(1962)—the ROR on that investment’s unrecovered balance.2
To determine the TRR on a project’s investment, several different
concepts have been developed in the technical literature since the first
approaches by Solomon (1956) and Baldwin (1959) were published.
However, for simple projects like Projects (1), (9), and (10) characterized
by a single investment followed by a string of positive returns, all these
concepts define the TRR in the same way: the TRR of such a project
is obtained by reinvesting in the market, at the MARR, the projects’
intermediate returns until the end of the project’s lifetime. Thus, a TRR

1 Theterm “True Rate of Return” was adopted from Adler (1970).

2 Accordingto Bernhard (1962, footnote 3, p. 22), the term “Unrecovered Investment,” also
called “Unrecovered Balance” (Bussey, 1978), was first used by the National Association of
Accountants (1959).
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192 M. M. Hajdasinski

for that project is obtained as an ROR defined by the initial investment

and the terminal cumulative return of that project.
After this is done for all three projects under consideration, an iden-
tical transformed CFP:

{−10,000; 0; 0; 16,550} (13)

will emerge, defining a TRR of 18.29%. This rate is smaller than any
of the IRRs, 23.38, 20.23, and 27.58%, of Projects (1), (9), and (10),
respectively, because the reinvestment rate of 10% is smaller than each
of the three IRRs. The above TRR is identical for all three projects
because, in this case, it is a genuine ROR earned on those projects’
identical investments, rather than on their unrecovered balances.
It should also be noted that the identical NPVs of CFPs (1), (9), and
(10) will not change when their intermediate returns are reinvested for
the purpose of the TRR calculation. Consequently, the transformed CFP
(13) has the same NPV as the three CFPs. This is due to the fact that the
reinvestment rate is the same one that is used for calculating the NPV.

Ambiguous Financial Indicator IRR

It has already been pointed out that an IRR itself is actually not the
interest rate that it is commonly assumed to be, and that the practice of
ranking PFAs by directly comparing their IRRs cannot be conceptually
justified. In addition, a comparison of the IRRs of two PFAs can easily
run into serious interpretational problems if the original, fully equity-
financed projects are more diverse than those used in Tang and Tang’s
simple numerical examples.
To illustrate, consider the following equity-financed project:

{−8000; 39,200; −62,500; 32,200} (14)

with an intermediate investment and three sign changes in its CFP.

Projects like this are quite common in the mining industry, for example,
where a mine may start its operations as an open pit and then move under-
ground, following a mineral deposit. This transition requires additional
substantial infrastructure investments, which can easily be much higher
than the initial investment. Project (14) produces three IRRs: 15%, 75%,
and 100%, and legitimate questions now arise: which of these rates, if
any, should be considered this project’s representative financial indica-
tor, and why?
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The Internal Rate of Return (IRR) as a Financial Indicator 193

To complicate the problem even further, let us assume that a market

loan of $7,000 at the MARR of 10% is possible, and that the principal will
be paid in two installments, $2,000 and $5,000, in the second and fourth
year of the project lifetime, respectively. This leads to the following
market borrowing project:

{7000; −2700; −500; −5500}, (15)

which, combined with CFP (14), creates the leveraged CFP:

{−1000; 36,500; −63,000; 26,700} (16)

Because the NPV, at the MARR = 10%, of borrowing Project (15) is,
by definition, equal to 0, the NPVs of Projects (14) and (16) are identical,
and equal to $159.83. Furthermore, CFP (16), similar to the previous CFP
(14), also produces three IRRs: −28.91%, 8.21%, and 3370.70%, which
again calls for a sound approach to the determination of Project (16)’s
representative IRR indicator. Using the Tang and Tang methodology, this
financial indicator could then be compared with a similar one selected
or derived from the three IRRs of Project (14). Unfortunately, Tang
and Tang do not address in their considerations the so-far-unresolved
problem of the financial interpretation of multiple IRRs, which has,
over the years, generated strong interest among researchers (Arrow &
Levhari, 1969; Cannaday, Colwell, & Paley, 1986; Flemming & Wright,
1971; Hajdasinski, 1987; Hazen, 2003; Jean, 1968; Kirshenbaum, 1964;
Lorie & Savage, 1955).
In contrast with the indeterminable representative IRRs of CFPs (14)
and (16), the unique TRRs of those CFPs can easily be determined.
Choosing the external rate of return (ERR) (White, Case, & Agee, 1976)
as an NPV-compatible TRR concept, the transformed CFPs derived from
CFPs (14) and (16) are obtained by reinvesting in the market, at the
MARR = 10%, each CFP’s year-two CF until the end of the CFP’s
lifetime.
This leads to the following two transformed CFPs:

{−8000; 0; −62,500; 79,632}, (17)

created from CFP (14), and

{−1000; 0; −63,000; 70,865} (18)

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194 M. M. Hajdasinski

generated from CFP (16). While the NPVs of the two CFPs are, for
reasons explained earlier, identical ($159.83), and are the same as the
NPVs of their parent CFPs, the TRRs produced by CFPs (17) and (18)
are different from one another and equal to 10.26% and 10.35%, re-
spectively. If compared directly, they would indicate the superiority of
the leveraged Project (18), and thus contradict the outcome of the NPV
evaluation. Initially, this may look surprising, since a TRR, unlike an
IRR, does represent an actual ROR on investment. However, one also
needs to realize that the investment patterns in Projects (17) and (18) are
quite different, which explains the differences in their respective returns.
To properly rank Projects (17) and (18) by means of the TRR criterion
(or any other NPV-compatible one), the incremental approach is called
for. Defining the generic differences between CFPs (17) and (18) leads
to the following incremental CFP:

{−7000; 0; 500; 8767} (19)

which, after reinvesting CF 500 for one year, will change into a trans-
formed CFP:

{−7000; 0; 0; 9317}. (20)

Project (20)’s ROR of 10%, tantamount with the TRR of Project (19),
is the same as the MARR, which indicates that neither of the two Projects,
(17) and (18), dominates the other. This judgment is also supported by
the zero-valued NPV of Project (20), which demonstrates again that
ranking mutually exclusive projects by directly comparing their TRRs is,
generally, not a sound approach. The only exception when this approach
can be applied in the NPV-compatible fashion is when the transformed
projects to be ranked exhibit identical patterns of investments in the
case of ranking investment projects, or identical patterns of borrowings,
if borrowing projects are being ranked. In all other cases the incremental
approach should be applied.

MISLEADING NPV-FUNCTION PROFILES

Finally, it should be noted, that Figure 1 from Tang and Tang

(2003, p. 70) presents misleading NPV-function profiles associated with
Projects A and B. The two profiles are clearly depicted as straight lines,
whereas, in fact, they are exponential in character. An oversimplified
straight-line NPV-function profile implies that the NPV-function at the
lower end of the economically meaningful domain (−100%, +∞) of
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The Internal Rate of Return (IRR) as a Financial Indicator 195

the discrete interest rate i tends toward a finite value. In reality, however,
this function approaches a vertical asymptote located at i = −100%,
tending either toward −∞, if the last non-zero CF in the project’s CFP
is negative, or toward +∞, if that CF has a positive sign.
The misleading NPV-function profiles also suggest that the NPV-
function tends toward −∞ as i tends toward +∞. In reality, however, as
i tends toward +∞, the NPV-function approaches a horizontal asymp-
tote that is defined by the value of the time-zero CF in the project’s
CFP. Using “free-style” graphs for conceptual illustration purposes is a
common, helpful, and accepted practice; however, such graphs should
always reflect the basic features of the functions involved.

CONCLUSION

The above comments point out that, regardless of whether the IRR
is interpreted as a financial or economic indicator, its generic defini-
tion remains the same; hence, the same must also remain the IRR-
based project-evaluation, and project-ranking principles, whatever this
criterion’s intepretation. Accordingly, the ranking of projects, or their
financial alternatives, by ranking their IRRs is, generally, conceptually
unsound. The correct approach to ranking competing mutually exclusive
alternatives, using the NPV, or any NPV-compatible evaluation criterion
(Hajdasinski, 1993), including the IRR, is the incremental approach.
Other issues associated with the use of the IRR as an economic or
financial evaluation tool are its actual interpretation, and its ambiguity
when a project produces multiple IRRs within the economically mean-
ingful range (−100%, +∞) of the discrete interest rate. In this context,
it is reiterated that, contrary to its popular interpretation, the IRR does
not define the ROR on a project’s investment, but rather one on this in-
vestment’s unrecovered balance (Bernhard, 1962; Brigham et al., 1994).
To circumvent the interpretational and operational problems caused
by the IRR, several ROR indices have been proposed in the technical
literature to reflect a project’s TRR. One of them, the ERR (White, Case,
& Agee, 1976), was chosen to demonstrate its IRR-like application. It
was also emphasized that, except for special cases, the ranking of mutu-
ally exclusive projects by means of this NPV-compatible IRR substitute
should be done by means of the incremental approach.

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BIOGRAPHICAL SKETCH

MIROSLAW M. HAJDASINSKI holds a B.Sc. and an M.Sc. in mining engineering from the
Technical University of Mining and Metallurgy (AGH) in Cracow, Poland. He earned
his Ph.D. in mine economics from the same university. Subsequently, Dr. Hajdasinski
conducted research at the Technical University Clausthal, Germany (Department of
Mining Engineering and Mine Economics), and at the Technical University Eindhoven,
The Netherlands (Department of Industrial Engineering and Management Science).
Late in 1982, he joined Laurentian University of Sudbury, Ontario, Canada, where he
currently works as a professor in the School of Engineering. Dr. Hajdasinski’s research
interests embrace project evaluation techniques and applications of engineering economy
and operations research to mine planning and evaluation, as well as to mine-design
optimization. He has published numerous articles in international journals and presented
papers at national and international conferences on the above subjects. Dr. Hajdasinski
is a professional engineer registered in the Province of Ontario.