---
title: "IRR drawbacks and how ERR removes them"
subject: "Engineering Economics"
chapter: 3
key: "semester_6/engineering_economics:irr-drawbacks-err-eliminates"
source: https://www.bctengineer.com/q/semester_6/engineering_economics/irr-drawbacks-err-eliminates
site: BCT Engineering
---

# IRR drawbacks and how ERR removes them

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

- Asked in: 2068 Jestha, 6 marks
- Video: [External Rate of Return - Engineering Economics Lightboard](https://www.youtube.com/watch?v=jV6LVt9D1fY) — Engineering Economics Guy
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_6/engineering_economics/irr-drawbacks-err-eliminates
- Whole chapter: https://www.bctengineer.com/md/semester_6/engineering_economics/chapter-3

## Question

What are the drawbacks of IRR method? How does ERR method eliminate some of these drawbacks?

## 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.

## Answer

#### Drawbacks of the IRR method
1. **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.
2. **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.
3. **Mutually exclusive alternatives.** Choosing the project with the highest IRR can give a wrong choice; the incremental investment must be analysed separately.
4. **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.
5. **Tedious calculation.** It needs trial and error and interpolation, and the answer is approximate.
6. **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%).

## Check yourself

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

1. How does ERR handle multiple sign changes?
   A. It also gives multiple values
   B. It gives a single value for any pattern
   C. It cannot be used
   D. It ignores outflows
   Answer: B. The ERR equation has only one root. (Key point: Multiple IRRs)

2. What reinvestment rate does ERR use?
   A. An explicit external rate epsilon
   B. The IRR
   C. Zero
   D. The inflation rate only
   Answer: A. Usually MARR or a safe market rate. (Key point: Reinvestment)

3. Which relation defines ERR?
   A. (1+ERR)^N = PW(inflows)/FW(outflows)
   B. ERR = IRR - e
   C. (1+ERR)^N = FW(inflows at e) / PW(outflows at e)
   D. ERR = sum of flows / N
   Answer: C. Outflows to year 0, inflows to year N. (Key point: ERR equation)

4. What does ERR still not fix?
   A. Multiple roots
   B. Unrealistic reinvestment
   C. Trial and error
   D. Scale, so incremental analysis is still needed for mutually exclusive projects
   Answer: D. ERR depends on epsilon and ignores size. (Key point: Remaining limits)

## Related in Engineering Economics

- [Define IRR; find IRR and ERR of project](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Airr-err-define-project-15) — Engineering Economics, chapter 3, asked 2×
- [IRR by AW, both BCR by FW, and ERR](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Airr-aw-bcr-fw-err-250000) — Engineering Economics, chapter 3
- [Drawbacks of IRR method](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Adrawbacks-of-irr) — Engineering Economics, chapter 3, asked 3×
- [IRR choose best of four, 10-year study](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Airr-choose-best-abcd-study-10) — Engineering Economics, chapter 4

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