- 2068 Jestha · 6 marks
IRR drawbacks and how ERR removes them
Short answer
IRR may give multiple rates, assumes reinvestment at IRR, and misranks projects. ERR uses a realistic external rate ε, giving a single value and avoiding unrealistic reinvestment, solving multiple-root issues.
What are the drawbacks of IRR method? How does ERR method eliminate some of these drawbacks?
Drawbacks of the IRR method
- Multiple IRRs. A cash flow with more than one sign change (e.g. −, +, −, +) can give more than one rate, or none. Then IRR cannot be used reliably.
- Reinvestment assumption. IRR assumes the money released by the project is reinvested at the IRR itself. A project with IRR 40% would need other investments at 40%, which is unrealistic.
- Mutually exclusive alternatives. Choosing the project with the highest IRR can give a wrong choice; the incremental investment must be analysed separately.
- Ignores scale. A small investment with a high IRR can look better than a large one with a smaller IRR but a larger total profit.
- Tedious calculation. It needs trial and error and interpolation, and the answer is approximate.
- Not defined for some cash flows (all positive or all negative flows).
How ERR (External Rate of Return) removes some of them
ERR uses an explicit external reinvestment rate ε (usually the MARR or a safe market rate). All net outflows are discounted to year 0 at ε and all net inflows are compounded to year N at ε:
(1 + ERR)^N = FW(inflows at ε) / PW(outflows at ε)
| Drawback of IRR | Effect with ERR |
|---|---|
| Multiple IRRs | ERR gives one single value for any cash flow pattern, because the equation has only one root |
| Unrealistic reinvestment at IRR | Reinvestment is at the realistic rate ε |
| Hard computation | Direct formula, no trial and error needed (just a root) |
| Wrong ranking of projects | Closer to the NPV result, since reinvestment is at a common rate |
ERR still depends on the chosen ε and still ignores project size, so the comparison of mutually exclusive projects should still use incremental analysis, but it fixes the main problems of multiple roots and reinvestment.
Example: for CF = −90, 25, 40, −30, 50, 75 with ε = 14%, ERR = 16.2%, while IRR = 18.1% (higher, because it assumes reinvestment at 18.1%).
✓ Answer checked by Claude Opus 5.5 (high effort)
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