Project A: investment Rs 2 crore, IRR 35%, NPV Rs 1 crore. Project B: investment Rs 50 crore, IRR 21%, NPV Rs 15 crore.
The board chooses Project A because 35% is higher than 21%. The decision feels right. The percentage is better.
The decision is wrong. Project A creates Rs 1 crore of value. Project B creates Rs 15 crore. The company chose the higher percentage and rejected Rs 14 crore of value creation.
IRR is a rate. It does not measure the scale of value creation. It measures the return per rupee of investment. A project that earns 35% on Rs 2 crore creates far less value than one that earns 21% on Rs 50 crore, because the absolute value created depends on both the rate and the base.
Why IRR Misleads
Scale blindness
IRR treats a Rs 2 crore project and a Rs 200 crore project identically: both produce a percentage. The percentage ignores the scale of the commitment and the scale of the value created. A board that ranks projects by IRR will consistently favour small, high-return projects over large, lower-return projects that create substantially more total value.
Reinvestment assumption
IRR implicitly assumes that the cash flows generated by the project can be reinvested at the IRR itself. Project A with a 35% IRR assumes the cash flows can earn 35% when reinvested. This assumption is almost never realistic. The modified IRR (MIRR), which assumes reinvestment at the company’s WACC rather than the IRR, produces a lower, more realistic return that often changes the ranking.
Multiple IRRs
Projects with unconventional cash-flow patterns (multiple sign changes: invest, receive, invest again, receive again) can produce multiple IRRs, making the metric meaningless as a decision tool.
Timing distortion
A project that returns cash quickly has a higher IRR than one that returns cash slowly, even if the slow project creates more total value. IRR favours speed over substance.
The Project Ranking Engine
In Northrop Management Private Limited’s capital allocation advisory, projects are ranked using a multi-dimensional framework that prevents IRR from dominating the decision.
NPV: Total value created. The primary ranking criterion.
IRR and MIRR: Return per rupee. Secondary criterion, useful for comparing projects of similar scale.
Capital intensity: How much capital does the project require relative to available capital? A project that consumes 80% of the capital budget may be the highest-NPV option but leaves no room for other opportunities.
Risk and downside: What is the maximum loss under the adverse scenario? A high-IRR project with a catastrophic downside may rank below a lower-IRR project with a manageable downside.
Strategic fit: Does the project advance the company’s competitive position, or is it an opportunistic financial return? Both are legitimate. They should be evaluated differently.
Liquidity impact: When does the project consume cash, and when does it return cash? A project with Rs 50 crore of front-loaded investment and returns beginning in Year 4 has a different liquidity profile from one with Rs 10 crore of investment and returns beginning in Year 1.
The ranking engine evaluates every project on all six dimensions simultaneously. The highest-ranked project is not necessarily the one with the highest IRR. It is the one that creates the most value, at acceptable risk, within available capital, with manageable liquidity impact and strategic coherence.
Ashish Chaudhary, frames the capital allocation discipline directly: “IRR tells you the return per rupee. NPV tells you the total value created. A board that ranks projects by IRR will consistently choose small, high-percentage projects and reject larger projects that create substantially more total value. The correct ranking criterion for most capital allocation decisions is NPV, constrained by capital availability, risk tolerance and strategic fit. IRR is an input, not a decision.”
Questions for the Boardroom
- When we compare investment options, do we rank by IRR alone or by a multi-dimensional framework that includes NPV, downside risk, capital intensity and strategic fit?
- For our most recent capital allocation decision, how much total value (NPV) was created by the approved projects, and how much was foregone by the rejected ones?
- Have we calculated the MIRR (using WACC as the reinvestment rate) for our major projects, and does the MIRR ranking differ from the IRR ranking?
- Are we systematically favouring small, high-IRR projects over larger projects that create more total value?
- Does our capital allocation process evaluate the liquidity profile (when cash goes out and when it comes back) alongside the return?
Closing Implication
The IRR trap is not a technical error. It is a psychological one: the preference for a higher percentage over a larger number. 35% feels better than 21%. Rs 1 crore of value does not feel better than Rs 15 crore. The board that sees both the rate and the total value makes a different, better decision. The board that sees only the rate optimises for the percentage and underinvests in scale.