Pitfall 1 — the scale problem. A small project earning 25% can create less absolute value than a larger project earning 12%. The percentage flatters the percentage; the owner is paid in dollars. Pitfall 2 — the timing problem. IRR implicitly assumes interim cash flows are reinvested at the IRR itself, which is rarely true; MIRR (Modified IRR) reinvests at the actual cost of capital and gives a more honest picture. Pitfall 3 — the multiple-IRR problem. Projects with cash flows that switch sign more than once (initial investment, big payout, then cleanup costs) can have two or three mathematically valid IRRs; the equation is non-monotonic. Pitfall 4 — the mutually-exclusive trap. Ranking projects by IRR and picking the highest can cause the firm to forgo the project that creates the most value.
| Decision | IRR-only answer | NPV-and-WACC answer | Owner takeaway |
|---|---|---|---|
| Two projects of very different scale, both above WACC | Pick the higher IRR | Pick the higher absolute NPV | Dollars compound, percentages don't |
| A project with two sign changes in cash flows | IRR is mathematically ambiguous | NPV at the WACC is unique and clear | Don't outsource the decision to a number that has two valid answers |
| A project where interim cash is reinvested at WACC, not IRR | Overstates returns | MIRR reflects realistic reinvestment | Match the assumption to reality |
| A project that earns above WACC but is small | Always say yes | Yes if no larger NPV alternative exists | Capital is finite; the opportunity-cost test never sleeps |
NPV = Σ [CF_t / (1 + r)^t] − Initial Investment
Worked example — Pelham Holdings is choosing between two reinvestment paths for $200M of free cash flow. Path A: a small specialty-line capacity expansion. $40M investment, expected to add $9M annually for ten years. IRR ≈ 19%; NPV at 9% WACC ≈ $17.7M. Path B: a major acquisition of a regional competitor. $200M investment, expected to add $24M annually for ten years. IRR ≈ 3.5%; NPV at 9% WACC ≈ −$46M. An IRR-first manager looking at A in isolation would approve it, then face Path B and (correctly) reject it. But a value-creator allocates the remaining $160M from path A's avoided spend to the next-highest-NPV opportunity — perhaps a buyback at a price below management's intrinsic estimate, perhaps a special dividend if no internal opportunity clears WACC. Buffett's favoured framing: 'The CEO's task is to allocate every dollar of retained capital to its highest-return use, including return to owners when no internal use earns above the cost.' Pelham's right move is Path A, plus a buyback or dividend for the residual.
Sit with the ideas.
Halton's CFO presents two mutually exclusive distribution-centre projects. Project NW: invest $4M, receive $1.5M annually for five years (IRR ≈ 25%). Project SE: invest $40M, receive $10M annually for five years (IRR ≈ 7.9%). The firm's WACC is 9%. From the long-term owner's perspective, which project should be approved?