Why IRR Fails as an Investment Rule and NPV Prevails

Name: Ep75 The Misleading Truth Behind IRR
Uploaded: 2026-04-04T00:14:13.849013+00:00
Duration: 26 min 8 s
Channel: Stanford Graduate School of Business
Description: Summary and key takeaways on Ep75 The Misleading Truth Behind IRR: Summary & Key Takeaways, covering The IRR vs. NPV Debate Net Present Value (NPV) is the

Stanford Graduate School of Business

Apr 04, 2026

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26 min video

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2 min read

YouTube video ID: oNn3fu_L91Y

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Net Present Value (NPV) is the standard tool for trading off costs and benefits that occur at different times. It discounts every future cash flow to the present using a chosen discount rate; a positive sum means the investment adds value. Internal Rate of Return (IRR) is a “thought experiment” that finds the discount rate that makes NPV equal zero. Because it represents the break‑even discount rate rather than a true rate of return, using IRR as a decision rule—invest if IRR exceeds the discount rate—is fundamentally flawed compared with the NPV rule. As one professor puts it, “The IRR is a horrendously bad investment rule.”

Pathologies of the IRR Rule

IRR’s mathematical behavior creates several serious problems. When cash flows change sign, the NPV curve can become U‑shaped, producing multiple IRRs or none at all. This “multiple IRR” issue forces analysts to make arbitrary exceptions. IRR also ignores scale: a 100 % return on a $1 investment is inferior to a 10 % return on a $1 billion project, yet IRR treats them as equivalent. Moreover, IRR’s reliance on the timing of cash flows makes it inconsistent; any change in the cash‑flow pattern can overturn the rule, unlike the stable NPV criterion.

The Impact of Financing

Allowing arbitrary financing plans makes IRR’s pathologies ubiquitous. An investor can manipulate IRR to appear arbitrarily high by choosing a financing structure that reduces the upfront outlay (ε) and pushes costs far into the future. As the upfront investment shrinks, the discount rate that drives NPV to zero climbs toward infinity, while the actual NPV collapses toward zero. In this scenario, “If I know you’re using the wrong decision‑making criterion, I can manipulate you.” The result is a seemingly impressive IRR paired with value destruction.

Practical Implications

Market‑based investments such as stocks typically avoid IRR pitfalls because they assume limited liability and negligible price impact for individual investors. By contrast, private‑equity firms and mutual‑fund managers frequently rely on IRR, ignoring its scale and timing blind spots. This misuse leaves them vulnerable to manipulation by actors who understand the true value‑maximizing criterion. The NPV rule answers the only question that truly matters: how much money can be made on the investment opportunity.

Takeaways

NPV remains the reliable standard for evaluating investments because it directly measures the present value of net benefits.
IRR is merely a break‑even discount rate, not a true rate of return, and using it as a decision rule leads to systematic errors.
The IRR rule suffers from multiple solutions, scale blindness, and timing inconsistencies, making it mathematically unstable.
Arbitrary financing structures can push IRR toward infinity while collapsing NPV, exposing a manipulation risk.
Private equity and mutual‑fund managers often misuse IRR, ignoring its flaws, whereas adhering to NPV safeguards against value destruction.

Frequently Asked Questions

How can a financing plan create an infinite IRR while reducing NPV to zero?

By reducing the upfront investment to a negligible amount and deferring most costs to the future, a financing plan shifts cash flows so that the discount rate that makes NPV zero becomes extremely high—approaching infinity—while the discounted sum of benefits remains near zero, effectively destroying value.

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Helpful resources related to this video

If you want to practice or explore the concepts discussed in the video, these commonly used tools may help.

Corporate Finance Textbook For Investment Analysis Recommended

Provides the foundational mathematical framework for NPV and IRR calculations, helping the reader move beyond the flawed IRR rule to value-maximizing investment strategies.

Amazon →

Financial Calculator For Business And Finance

A dedicated financial calculator allows for the manual computation of NPV and IRR, enabling the user to verify the pathologies discussed in the podcast.

Amazon →

Books On Investment Decision Making

Offers broader context on how professional investors evaluate opportunities, reinforcing the importance of NPV over misleading metrics like IRR.

Amazon →

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Summarize another video

Full Transcript YouTube

Welcome to the Lauder Institute at the
University of Pennsylvania. I'm Jules
Van Binsburgen, director of the
institute and a finance professor at the
Wharton School. And I'm Jonathan Burke,
a finance professor at the Graduate
School of Business at Stanford
University. This is the All Else Equal
podcast.
Welcome back everybody. Today we're
going to do an episode on a topic that
Jules and I have spoken about repeatedly
for I would say as long as we've known
each other, which is the internal rate
of return and specifically using the
internal rate of return as a criteria
for making an investment decision. Yeah
and Jonathan I think that the use of the
IR is ubiquitous both in the private
sector as well as in academia. I mean
the number of finance professors today
that essentially teach the IR as a
complimentary decision-m criteria with
the footnote that it may have certain
problems but still putting it almost on
equal footing with the net present value
or NPV criterion is quite shocking to
me.
>> Yeah. So, Jules, I teach the
introductory finance class. It's a
10-week class. I spend one week on IRRA
and why it is a horrendously bad
investment rule. And we wanted to talk
about this. You and I now have a paper,
which we're almost done, on the IRR
rule, and the paper makes a strong
claim, which is that it's not
exceptionally bad in a few cases, but
it's always a bad decision rule. And
that's a very strong claim. And maybe we
can explain this on this show. So why
don't we start Jules with explaining
what is the problem with the internal
rate of return. Well before we do that,
let's take even one further step back
which is let's talk about the net
present value and the IR in terms of how
they're defined. So generally what we
say is if you want to make a good
decision then you need to trade off
costs against benefits. And so if you
take the net of those two things you get
the net benefits of a decision. But of
course when you make a decision
generally the costs that you have are
not arriving at the same time as the
benefits. And so the field of finance is
particularly equipped to address the
issue of how do I trade off cost and
benefits that don't happen at the same
time. And the object that we use to
trade those two things off is what's
called to the discount rate. And
generally we say that if benefits happen
further into the future and or are
riskier that means that you value them
less as the risk goes up and as the time
that you have to wait for them goes up.
And what we do in that case is when we
bring all the cash flows to the present,
all the benefits to the present, all the
costs to the present and we subtract and
what you called the benefits outweigh
the costs. The word in finance is the
net present value of the investment is
positive. So that just basically says
all the present value in today's terms
of all the benefits exceed the present
value of all the costs and if that's
positive you make the investment
decision. Indeed. And so when we use the
acronym NPV, it has the N for net which
means the net of cost and benefits and
then PV present value meaning that
everything has to be comparable by
bringing them all to today's equivalent
in terms of value and we use the
discount rate to do that. Let's think
about the intuition of what a discount
rate does. So the way I always explain
it in class is the discount rate
essentially tells you how important the
present is relative to the future. So if
the discount rate is really low that
means that the future is very important
to you relative to the present. If the
discount rate is really high that means
that the future is not that important to
you in your decision-m. Now the internal
rate of return or IR is already if you
think about it an interesting object in
and of itself in that it is a thought
experiment. It is a thought experiment
that says you know we have used the
discount rate of say for example 12%.
But we're not going to be using that 12%
number. We're going to do the thought
experiment where we ask what should the
discount rate have been for the net
present value to be zero. So nobody is
arguing that that is the correct
discount rate. No, we're doing a thought
experiment where we're saying how far
could we push the discount rate in many
cases up if the net present value was
positive. So that then we can see how
far we can push that discount rate to
push the net present value to zero. So
in a usual investment rule it's that the
costs come up front and the benefits
come later. So that means that if for
the normal the discount rate that we're
using the NPV is positive. If I now
start to push the discount rate up I
make the future which has the good stuff
happening less and less important which
of course means that the NPV will come
down. If I make the discount rate high
enough, I make the benefit so irrelevant
that eventually we will reach the break
even point where the NPV is exactly
zero. And that's how the internal rate
of return is defined. And some people
take the outcome of that thought
experiment itself as a decision rule. So
Jules, there's a very good way to use
the rate that comes out of that thought
experiment because you in many many
cases you don't know the discount rate
very accurately
and what the thought experiment tells
you is how far off can you be such that
your MPV zero and so you can think of it
as a break even rate.
>> Yep. And that's a very useful thing to
know because if you have a positive NPV
project and it turns out if you're off
by 10 basis points in your discount rate
is a zero NPV project that tells you you
better have a lot of confidence in your
discount rate. But if let's say it's you
need to be off by 5% in your discount
rate, most likely you'll know your
discount rate within 5%. And so it's a
much more conf and that's a very useful
measure. And so I agree that break even
quantities in general when we do
sensitivity analysis when we make a
decision I think is a useful thing to
do. We often think about the break even
price or the break even quantity that we
need to sell or the break even tax rate
and in that sense we can also think
about the break even discount rate. And
actually, Jonathan, I'm happy that you
bring this up because I think that is
the perfect terminology for it. I don't
think it should be called the internal
rate of return. There's nothing internal
or rate of return about it in my
opinion. It's just the break even
discount rate. That's a much better name
for it. Exactly. The IRRa investment
rule works like this. Invest whenever
the internal rate of return exceeds the
discount rate. That's the rule. Now the
problem begins when we use it in another
sense. We say well if the discount rate
is less than the break even rate that
must be a good deal and so we use that
as a rule to make an investment. So now
Jonathan we are not the first ones to
bring up that this thing may have
problems and other people have pointed
out that in certain cases the usage of
this internal rate of return can have
problems and so let's list them very
clearly. So the first one is because
we're asking for a rate that makes the
net present value zero. If the cash
flows, the net benefits that we're using
don't have a nice pattern and they
switch signs, that means that this
thought experiment can have multiple
answers. So it's possible that you know
you get a break even discount rate where
the NPV is zero at 14%, at 27% and at
63%. And the intuition starts with the
fact that the rule could be exactly
wrong in all cases. So let's understand
that. So most people think of an
investment opportunity where you the
costs are up front and the benefits are
later on.
>> Yes. But imagine an investment
opportunity where the costs are later on
and the benefits are upfront. When I
teach the class, I teach a very salient
example which is if you're a textbook
author, often the way that works is they
pay you a upfront advance and then you
have to incur the cost of writing the
book. In that case, the internal rate of
return investment rule gives you exactly
the wrong answer. And the reason is
you're essentially getting a loan. So if
you're doing a regular investment and I
tell you the internal rate of return
that is the break even discount rate
exceeds
the actual discount rate and then you
say okay that's a great deal for me so I
should take it but if you get a loan and
I tell you the rate of the loan exceeds
the discount rate you're going no I
don't want to pay that high interest and
so you could think of the royalty
example is really a loan because you get
the money up front and then you have to
make the uh payments later, which is the
way a loan works. Well, the way you get
multiple IRS is after the end of the
work on the textbook and you've paid the
advance back, you eventually start
getting royalties and so it becomes a
mixture of a loan and an investment and
because of those mixtures, the shape of
the NPV curve can be U-shaped so you can
get multiple IRS. So related to the
example I gave earlier Jonathan about
the discount rate telling you how
important the future is now the good
stuff that you're talking about comes
first and the bad stuff comes later. So
obviously if you now increase the
discount rate you make the bad stuff
less important rather than the good
stuff and so therefore the whole
intuition switches around and so indeed
you have that issue that now the IR rule
gets it completely wrong and you have to
really be careful but once you start to
indeed mix scenarios and some of the
benefits happen in the future and some
of them happen now and some of the costs
happen in the future once you start to
play with the discount rate what are you
making more important relative to the
other piece can totally depend and it's
not even that you can just get a
U-shaped curve for the IR if there are
multiple good and bad things happening
in the future and they alternate you can
really get tons of different solutions
for the IR and now the question is what
am I supposed to do with that you know
if I get six different answers what
should the rule now be you know Jules
this is well and good but many students
when I teach this go oh he's being
technical we can reverse the rule when
uh when needed when the cash flows come
first Yes.
>> And there may be some truth to that. I
always respond when they say that well,
you know, having a simple rule that is
invest whenever the NPV is positive is a
lot easier than a rule that says invest
whenever the IRRa exceeds the discount
rate except for and then a whole bunch
of exceptions. But let's say you could
do that. That I don't think is the
there's still other issues with the IRRa
rule. Yeah. So, first Jonathan, it's
even possible that you don't get a
solution at all. What if there is no
break even point? What are you supposed
to do then when your students ask the
question, "Oh, you're being technical. I
can just change the rule. Tell me how
are you going to change the rule now if
there isn't a solution?"
>> Yeah.
>> Right. I always say to my students, if I
would raise my children with a set of
rules and in every situation that they
confront me with, I have to change the
rule to make it work for that particular
situation. That's called not a rule.
Right.
>> Exactly.
>> So the idea of rules should be that I
can consistently apply them and that
they work under all circumstances.
Otherwise, what are we really doing? But
now, let's go to what is an even bigger
problem with the IRRa?
>> Well, one of the biggest problem with
the IRRa is what I would call scale,
which is very closely related to another
problem, which is the timing of the cash
flows. But let's just talk about scale
because it's easy to understand. As I
tell my students, what would you rather
have a 100% return on $1 or a 10% return
on a billion dollars? And it's pretty
obvious. you'd much rather have a 10%
return on a billion dollars. But the IR
rule, since it's in returns, it's
tempted to say, I'd rather have a 1,000%
return than a 10% return. It ignores
scale. Yeah, for sure. And so, of
course, the implicit assumption that
people make when they use the IR is that
you can somehow make the scale
irrelevant. People say things like,
"Well, if you can get that super high
return that you just mentioned on the
$1, why couldn't you just get it on the
billion dollars, too?" And that I think
is one of the most fundamental mistakes
certainly academics make. Probably
business people don't make that mistake
cuz probably business people fully
understand the decreasing returns to
scale in every single business. In other
words, it's suboptimal to operate in the
increasing returns to scale part of the
production function. You've got
increasing returns to scale, increase
the size of the business. And so any
competent business is going to be
operating in the decreasing returns to
scale part of production function, which
means scale matters. And which means you
cannot use a rule that ignores scale.
And it's very closely related to the
timing of the cash flows. Because if you
remember the rule is usually stated on a
perom basis. So, if I tell you you make
a $1,000 investment today and you will
get back say $200,000 in a year from now
or $200,000 in 5 years from now, the
internal rate of return is going to be
different because it's stated on an
annual basis. And then you'll say to me,
well, of course it's different. You're
getting the cash flows later. Yes,
that's true. But let's say you were
getting the cash flows later, but the
cash flows were growing at a rate. It's
not then clear the IRRa rule gets it
right because it depends very much on
the rate at which those cash flows are
growing. Absolutely. And so Jonathan now
is a good time I think to talk about the
paper that we have right because a lot
of people say the problems that you have
pointed out they can occur but there are
also many situations where they don't
have to occur and aren't we just fine
and shouldn't we just try to avoid those
annoying scenarios where the problems
occur and just stick with the good parts
of it which is let's just hope and cross
our fingers that we're not in that part.
And so the paper that we wrote I think
makes a very strong point which says
that as soon as you can change the
timing of the cash flows through payment
plans. So as soon as you allow for
financing of your investment meaning for
example that you don't have to make the
full investment in a machine or in a
plant or in a car today but you're
allowed to pay it off with a payment
plan over time which of course is the
same thing as essentially taking a loan
for the investment that you're making.
that there exists a payment plan for
every single positive NPV investment
where you can make these problems occur.
Meaning that the scale can be made such
a problem that essentially if you can
choose the payment plan you can make the
IR any number that you like higher than
the original IR that you got when you
financed the whole thing up front. You
can come up with scenarios where you get
multiple solutions. You can have a
payment plan for which you have no
solutions. So for that reason these
pathologies of the IR they're not just
incidences they're such structural
problems that they're ubiquitous all the
time. Yeah. So let's just state what the
result of the paper is which is if you
allow financing every single project
will have a problem with IRRa. If you
allow any financing before we explain
that let's just start with the intuition
and let's start with a very simple
question. If you know maybe some of our
listeners they already thought about us
some of our very intelligent listeners
and they would have said you know
Jonathan you're telling us IRRa is a
terrible rule but essentially that's the
rule investors use every day in the
markets and it's true when investor do a
market investment they calculate the
rate of return on that investment which
is essentially the IRRa and you're
saying well J surely according to you
that means I'm making mistakes all the
time and my Students ask me that my very
brightest students who are on the ball,
this is what they say to me when we
start doing capital markets in that
course. And the answer is very simple.
An investment opportunity in the market
is usually a very simple opportunity
which is there's limited liability. So
the first cash flow is negative. You buy
all future cash flows are positive.
>> Yeah. So that immediately means there's
only one IRRa.
And the second crucial part of the
investment is we always assume that an
investor is small. And what that means
is the investor does not affect the
price. And that's equivalent to you can
invest at any scale. So the scale
problem goes away. Yeah. Let's say
definitely indeed we assume that the
scale problem isn't there because
assuming that the investor is small is
the same as saying there is no skill
problem. Let's be precise. Right.
>> Exactly.
>> Yes.
>> And so the first thing I point out to my
students is that's true for you and me.
It's not true for a mutual fund manager
>> or for Elon Musk. And you know the work
that Jules and I have done in mutual
funds is precisely predicated on people
making the mistake that a mutual fund
manager makes an investment and he
doesn't affect the price and that if you
realize that that's of course
unrealistic
then no you cannot use the IR rule to
evaluate a mutual fund manager. No, but
keeping on that intuition that if you're
small and you don't affect the price,
notice something that we always think
about it as an investment where we
ignore financing. But if we did not do
that, then the IRRa is arbitrary
because by simply financing, by buying
on margin, you can change the return of
your investment. So there's no fixed
return on investment if you allow people
to buy stock on margin. So there's
another implicit assumption which was
always talking about the return with no
financing.
And so now let's think about the idea of
a project where you allow arbitrary
financing. Now, so Jonathan, one thing
that we need to add to that, right, is
that there's even a link between
allowing for financing and assuming that
the scale is so small that you wouldn't
affect the price because if I can
aggressively use financing, I can
increase the scale that I have to an
arbitrary number that I like. Exactly.
So really the set of conditions where
you can use the return to evaluate an
investment opportunity is very very
small. Like for example, private equity,
people love to use IRRs to evaluate
their performance. It's just incorrect
in that context. In that context, the
scale is very limited. The timing is
very specific. And so using IRRa in the
private equity context, I think is one
of the big mistakes less sophisticated
investors do. I think more sophisticated
investors understand. And when they are
given historical IRRs, they take those
IRS with a great salt. And there's one
more thing that we need to talk about
Jonathan that the paper shows which is
that if you take financing you can boost
your IR but if you take financing at
unfavorable rates you may still boost
your IR and yet undermine your NPV
meaning you are really hurting the total
value that you're extracting but you're
making your IR numbers look good. So a
really prevalent example of this
particularly in the sector that you just
described is if you know that somebody
uses irr and you ask them you know would
you rather pay for the investment up
front or would you rather take a leasing
plan at an unfavorable interest rate if
the person uses the IR they will pick
the leasing plan at the unfavorable
interest rate and destroy value just to
make the IR look better.
>> Yes. Jules, I think we should talk about
the example you came up with that I use
every year after you came up with it.
It's such a beautiful example. You came
up with an example where you said,
"Okay, let's just consider an
investment, positive NPV investment,
standard or positive NPD. The person
makes an investment and it pays off in a
USA." And then what you do in that
example is introduce a financing plan
where instead of making the investment
today, you only invest one penny today
and then you pay it back at the in the
future when your revenues come. And
obviously that IRRa is close to infinity
because you're investing a penny and
you're getting something in the future
and you can invest half a penny and a
fraction of a penny and each time you
reduce the investment and move the money
to the future, you send the IRO to
infinity. The first part of the example
you came up with is to show students
they can pick any IRRa they want just
based on how much they want to invest
today using the financing plan. And then
the second part of the example you came
up which is I think is beautiful is you
then consider a financing plan at to a
higher rate such that what happens is
the person borrows almost all the
required investment leaving just an
epsilon amount that they have to invest
and then they in the future the payout
has to be a lot higher than epsilon.
Exactly. But if epsilon is small then
the ratio of the payout to the
investment is still a very high number.
In other words, you can send the IR to
infinity and if the financing rate is
sufficiently above market, you can send
the NPV towards zero. So by taking an
unattractive financing plan, you can
generate a project for which the NPV
approaches zero while the IR approaches
infinity and all the money goes to the
person financing the project. It's a
wonderful example, very simple example
of if you use the IRRa rule, the
financing person can take the NPV away
from you.
>> Yeah. And I think that that is a very
important theme in finance in general,
Jonathan. But today in class, we had a
long discussion about this too where
people were telling me like, well, if
everybody uses EB down multiples, why
shouldn't we be using it? Then I said to
them, just like with the IR, if I know
you're using the wrong decision-m
criterion, I can manipulate you because
if I know what the right decision-m
criterion is and I know you use the
wrong one no matter what, then you know
I can take advantage of you. That's a
very good point, Jules. Excellent point.
And that's something that's so
important. And you know, I just feel as
if as finance professors, we don't
emphasize that enough. When I talk about
the NPV rule, at one point early in my
career, I taught a class to
undergraduates and it was great. And
then one of the undergraduates, one of
my best students came to see me
afterwards and then he was telling me
that he was taking accounting class. In
the accounting class, they were using
the IRA rule and he said to the
professor, "No, no, no, no. Professor
Burke said, "You got to use NPV." And
the professor started arguing with him
and he said to me, I couldn't argue
back, "Professor Burke, why do you use
the NPV rule?" And I was like devastated
because it was quite clear I hadn't
taught anything. And from that day
onwards I said I would make sure that my
students understood. And when I sit
there and teach NPV I say to them the
NPV rule answers the only question
you're interested in having answered
which is how much money can I make on
the investment opportunity? any other
rule if it answers that question it has
to be the MPV rule because the MPV rule
answers that question and if it doesn't
answer that question then it's not
telling you how much money you can make
on the investment opportunity it is
telling you something else
>> yes for sure
>> and play since it's telling you
something else somebody can manipulate
you
>> yeah I love that example I mean although
I would say how much value do you add
and that of course is the same as the
amount of money that you make agreed and
indeed in the end A good decision can
only be based on the correct
decision-making criterion. So if I have
three decision-m criterion and they give
me three different answers, what am I
supposed to do with that? Well, I can't.
As you point out, there's always a best
way of doing something.
>> Yes.
>> So you can't have three best ways of
doing something. And as it turns out, if
your objective is to make as much money
as possible or is add as much value as
possible, that's the NPV. Those are
synonymous. So any other decision at all
is not optimal. it's not giving you what
you want. And so this most surprising
answer to me that I get from people is,
"Yeah, but doesn't the IR give the same
answer as the NPV rule in many cases? So
is it then fine?" And then I'm like,
"Well, but if it giving the same answer,
then what do you need the new decision-m
criterion for? Didn't you already have
the decision-making criterion then?"
>> But it isn't. It does not give the same
answer as the NPV. We just gave examples
where it doesn't. And that can be used
to manipulate the situation.
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