Another Dark Side of IRR - Excessive Leverage, Increased Default Risk and Wealth Destruction

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.

Keywords: NPV, IRR, Default Risk, Optimal Capital Structure

JEL Classification: G12, G31, G32, G33