MODIFIED IRRIn particular, the IRR formula may have multiple solutions if the cash flow stream to which it is applied has sign reversals. Such sign reversals occur when the cash flow switches from positive to negative and vice versa (Greer and Farrell, 1992). For this reason, the results of the IRR formula should be viewed with caution when applied to such cash-flow patterns.
The other problem of the IRR formula is the reinvestment assumption. In particular, the IRR formula calculates the internal rate of return assuming that any positive cash flow from each period is reinvested at a rate equal to the estimated IRR (Greer and Farrell,1992; Brueggeman and Fisher,1993). This may create biases to either direction, if the estimated IRR is unrealistically high of low compared to investment rates immediately available to the investor when the cash flows of each period are received. For example, an estimated IRR of 35%, incorporates the assumption that all cash flows received over the holding period will be reinvested at a rate of 35%. However, if the investor can only reinvest the cash flows that are received at a rate of 8%, then the estimated IRR is biased upwards and the true IRR is lower, given the realistic reinvestment rate. Similarly, if the estimated IRR is 5% and the realistic and feasible reinvestment rate of periodic cash flows is 8%, then the truly achievable IRR will be higher. The formulas for the estimation of the modified IRR are discussed with example in the e-book Real Estate Investment Mathematics.
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