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Internal Rate of Return
 

Point of criticism: The tied-up and free capital







Limitation of the internal rate of return(IRR): capital bound

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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