Drawbacks of IRR method

The internal rate of return (IRR) is the rate at which the PW of a project's cash flows is zero. It is popular, but has these drawbacks.

1. Multiple IRRs. If the net cash flow changes sign more than once (non-conventional flows, e.g. -, +, -, +), the PW equation can have more than one positive root (Descartes' rule). Then no single IRR is meaningful.
2. Reinvestment assumption. IRR assumes that the recovered cash is reinvested at the IRR itself, which is unrealistic for a very high (or very low) IRR. Real reinvestment is nearer the MARR.
3. Wrong ranking of mutually exclusive projects. Comparing the IRR of two projects can pick a project with a higher rate but a smaller total gain. An incremental IRR analysis is required (compare the extra investment), which is more work.
4. Ignores project size and scale. A small project with a high IRR may look better than a large one with a lower IRR but larger absolute profit.
5. Computation. Finding IRR needs trial and error with interpolation, or a computer, and is tedious by hand. It cannot be found in closed form.
6. Not defined for some cash flows. If all flows are costs or all are benefits, or the cash flow has no real root, IRR does not exist.
7. Unequal lives. Alternatives with different lives need extra assumptions (such as repeatability) before they can be compared by IRR.

Because of these problems, the ERR (external rate of return) method or NPV/AW are preferred when cash flows are non-conventional.