Point of criticism: The tied-up and free capital
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Criticism of the net yield computation according to the IRR-method
The internal rate of return (IRR) as measure for investment success is not completely undisputed. The criticism
aims at the fact that the computed net yield only takes the capital tied-up in the investment into account. The free
capital remains unconsidered. If, during an investment, the bound capital changes precipitously, the calculated net yield
after IRR does not describe the success of an investment and does not lead to meaningful results.
Example: Stock Trading
Buy: 10000 01.01.2004 security A bound capital: $ 10000
Dividend -200 10.03.2004 9800
Sell -4500 11.03.2004 security A 50% 4300
Buy 4200 10.12.2004 security B 9500
Sell -5200 31.12.2004 security A 50% 0
Sell -5600 31.12.2004 security B 0
Sums: Investments: 14200
Returns: 15500
Gain: 1300
Yield (IRR) : 20,05 %
Yield related to $ 10000 = 1300/10000 = 13%
As one sees clearly in this example the internal rate of return is unsuitable to describe the success of this
type of business activity. This is because the complete $ 10000 was needed for this type of deal. When it is not
invested, it has to wait for daily availability.
The IRR calculation only considers the bound capital. For the capital not tied up, it is assumed that it is paying
the same interest as the bound capital. In reality that is not always possible.
One should not exaggerate this fact. Just keep in mind that you should not only consider the yield but also
bound capital you obtain it on.
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invest-faq.com
Theory site with articles from many contributors, which are specialists in the different topics.
Modified Internal Rate Of Return - MIRR
The MIRR more accurately reflects the profitability of a project.
Economics Interactive Tutorial
Perils of the Internal Rate of Return.
Internal rate of return: A cautionary tale
Article about the limitations of the IRR-method.
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