---
title: "Drawbacks of IRR method"
subject: "Engineering Economics"
chapter: 3
key: "semester_6/engineering_economics:drawbacks-of-irr"
source: https://www.bctengineer.com/q/semester_6/engineering_economics/drawbacks-of-irr
site: BCT Engineering
---

# Drawbacks of IRR method

Engineering Economics · Chapter 3: Basic Methodologies of Engineering Economic Analysis

- Asked in: 2076 Shrawan, 4 marks; 2067 Mangsir, 4 marks; 2065 Chaitra, 4 marks (asked 3 times)
- Video: [Drawback of IRR | Internals rate of return method | MARR | Engineering economics](https://www.youtube.com/watch?v=9y8YZHuqDac) — Sudip Dhakal
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_6/engineering_economics/drawbacks-of-irr
- Whole chapter: https://www.bctengineer.com/md/semester_6/engineering_economics/chapter-3

## Question

Explain the drawbacks of IRR method.

## Short answer

IRR can yield multiple rates for non-conventional cash flows and assumes intermediate cash is reinvested at the IRR itself, which is unrealistic. It may misrank mutually exclusive projects, ignores project scale, and requires trial-and-error computation.

## Answer

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.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. When can a cash flow have more than one IRR?
   A. When all flows are positive
   B. When net cash flow changes sign more than once
   C. When the project life is short
   D. When MARR is high
   Answer: B. Non-conventional flows with multiple sign changes can give multiple positive roots (Descartes' rule). (Key point: Multiple IRRs)

2. What does IRR assume about recovered cash?
   A. It is reinvested at the MARR
   B. It is not reinvested
   C. It is reinvested at the IRR itself
   D. It is reinvested at the bank rate
   Answer: C. This is unrealistic for very high or low IRRs; real reinvestment is nearer the MARR. (Key point: Reinvestment assumption)

3. Why can ranking mutually exclusive projects by IRR mislead?
   A. The higher IRR may carry a smaller total gain, so incremental IRR is needed
   B. IRR is always the same for all projects
   C. IRR ignores the time of cash flows
   D. Higher IRR always means higher NPV
   Answer: A. IRR ignores scale; compare the extra investment with incremental analysis. (Key point: Mutually exclusive projects)

4. Which methods are preferred for non-conventional cash flows?
   A. Simple payback only
   B. Plain IRR
   C. Accounting rate of return
   D. ERR, NPV or AW
   Answer: D. ERR, NPV and AW avoid the multiple-root problem. (Key point: Preferred alternative)

## Related in Engineering Economics

- [IRR drawbacks and how ERR removes them](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Airr-drawbacks-err-eliminates) — Engineering Economics, chapter 3