Another Dark Side of IRR – Excessive Leverage, Increased Default Risk and Wealth Destruction
Alexander D.F. Lahmann
Handelshochschule Leipzig (HHL)
Maximilian Schreiter
Handelshochschule Leipzig (HHL)
Bernhard Schwetzler
HHL Leipzig Graduate School of Management – Department of Finance
June 14, 2016
Abstract:
The internal rate of return (IRR) is still a widespread criterion for investment decisions, although many pitfalls are well known. This paper provides evidence for another, more fundamental, dark side of IRR: Based on a dynamic model of optimal capital structure with endogenous bankruptcy trigger and risk-adjusted yield of debt we show that capital structures maximizing IRR are suboptimal, i.e., not value maximizing. The IRR criterion triggers the choice of higher leverage increasing the risk of default. Depending on the parameter setting the net benefit of financing reduces by up to 50 per cent. As optimizing the financing structure based on IRR is popular in PE related settings, our results are especially important for this industry.
Another Dark Side Of IRR – Excessive Leverage, Increased Default Risk And Wealth Destruction – Introduction
The internal rate of return (IRR) reflects the discount rate making the net present value (NPV) of an investment’s cash flow stream equal to zero. Many pitfalls of applying the IRR are well-known for decades and represent a standard chapter in graduate textbooks on financial economics: Implicit assumptions about the reinvestment rate may lead to value-destroying investment choices, fading out absolute present values may yield wrong rank-orders for mutually-exclusive projects, multiple or non-existent IRRs may make it impossible at all to be used as decision criterion (see for instance Brealey et al., 2011, for an overview).
Despite the academic critique, many investment and financing decisions in practice are still based on IRR with the remark that the mentioned pitfalls only exist in specific setups and can be controlled. Graham and Harvey (2001) find 75:7% of CFOs in their survey to rely on IRR for capital budgeting decisions. Within the private equity (PE) industry the IRR is even more prevalent: Gompers et al. (2015) report that 92:7% of PE investors use the IRR as a key parameter to value their equity investments and, compared to other decision criteria, rank it first in importance. Also well-known advisors like Deloitte (2015) or EY (2015) ocially apply the IRR to determine the success of investments.
Textbooks on project finance and PE confirm practitioners by describing the Equity IRR, the discount rate at which the initial equity investment equals the present value of future equity cash flows, as “the most usual measure used by Sponsors and other investors to determine whether a project investment is viable” (Yescombe, 2013, p. 314). Even more alarming is the growing use of the Equity IRR as a key metric in academic publications. Kaplan and Schoar (2005), Nikoskelainen and Wright (2007), Valkama et al. (2013) and Achleitner and Figge (2014) apply the Equity IRR as a performance measure to derive success factors in PE investments.
As illustrated by Rosenbaum and Pearl (2009) in an LBO case study and empirically proven by Valkama et al. (2013), the Equity IRR is severely influenced by capital structure decisions. Increasing leverage triggers higher Equity IRRs while the Enterprise IRR is not significantly aected. The correlation between the two measures “is only 0.64 (significant at the 1%level), which shows the significance of the variation between these two” (Valkama et al., 2013, p. 2382).
While authors usually list the general drawbacks of IRR and claim that it should still be used because of its intuitiveness (see for instance Gatti, 2012; Viebig et al., 2008), they have never discussed the particular implications of applying the Equity IRR.
To address this issues, we develop a dynamic structural model which allows for an integrated analysis of firm values and optimal capital structures (such as Leland, 1994; Goldstein et al., 2001). In particular, this is an EBIT-based, infinite time horizon model where equityholders maximize one of the classic decision criteria, NPV or IRR, by endogenously choosing a static debt level and the optimal default level. Such a simplified setting allows us to focus on the eects of the investment decision criteria upon optimal capital structure choices, and avoids mixing up our results with other issues such as the optimal redemption policy or maturity structure. Our model is based on a barrier options technique where the stochastic EBIT-process represents the underlying while the lower barrier is defined by the optimal default trigger.
As a result, we obtain another, fundamental, detriment of IRR: Capital structures maximizing the Equity IRR are not value maximizing but reduce investors’ wealth. Moreover, investors led by the Equity IRR criterion always choose higher levels of debt (leverage) and, thus, increase the default risk significantly. The NPV-maximizing version of the model arrives at results similar to Leland (1994).
The remainder of the article is structured as follows. Section 2 introduces our basic model setting. Subsequently, we develop the optimal capital structure choices for maximizing the NPV (Section 3) and the IRR (Section 4). In Section 5 we present a formal proof of the IRR’s additional detriment followed by a numerical application illustrating the severeness of our findings. Section 6 concludes the analysis.
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