"IRR" vs. "NPV" and What You Need to Know

For those of us who've spent some time in MBA school, the investment-evaluation metrics called "IRR" (Internal Rate of Return) and "NPV" (Net Present Value) are extremely familiar.  Your HP 12C calculates them faithfully.

Leave it to McKinsey to lay out in pellucid terms all the myriad failings of IRR vs. NPV.  The bottom line:  Avoid using IRR entirely.

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.

Law firms, consciously or otherwise, are "investing" all the time:

• in real estate commitments;
• in associate training programs;
• in lateral acquisitions;
• in IT initiatives;
• in business development.

These investment decisions deserve serious professional scrutiny; it is, need we remind you, the partners' money.  If the analysis is based on IRR, come back to this post and take another look at what McKinsey has to say.