What are its fallacies? Primarily, it implicitly assumes that interim cash flows from the investment (if any) can and will be reinvested at the pre-defined IRR rate, whereas NPV only assumes that interim cash flows will be reinvested at a rate needed to recover the firm's cost of capital. Arcane this may sound, but IRR ends up making investment projects look attractive on the false premise that there is an endless supply of equally attractive interim projects. How serious can this flaw be?
According to McKinsey, they recently reviewed 23 major capital projects approved over five years at a large industrial company with an average IRR of 77%. With the return on capital adjusted to the company's average rate, the average return fell to 16%. More important for financial decision-makers, the most-highly rated project by IRR fell to 10th place on the revised analysis.
If the analysis is based on IRR, come back to this post and take another look at what McKinsey has to say.
