Negative IRR indicates that the sum of post-investment cash flows is less than the initial investment; i.e. the non-discounted cash flows add up to a value which is less than the investment.
So yes, both in theory and practice negative IRR exists, and it means that an investment loses money at the rate of the negative IRR.
In such cases the net present value (NPV) will always be negative unless the cost of capital is also negative, which may not be practically possible.
However, note that a negative NPV doesn’t always mean a negative IRR. It simply means that the cost of capital or discount rate is more than the project IRR.
In this post we will explore the concept of negative IRR and also touch upon the issue of multiple IRRs.
Let’s consider the following cash flow stream:
You will notice that the sum of all the cash flows is negative.
We can calculate the IRR by using the Excel IRR function:
You will notice that the IRR is -2.6.
What does it mean? You are investing 600 and getting back 560, so you are losing 40 over the cash flow period. So the IRR -2.6 is the rate at which you are losing money.
Such scenario is very much possible in real life situations, and there is nothing wrong with your analysis if you get negative IRR.
IRR is often defined as the theoretical discount rate at which the NPV of a cash flow stream becomes zero. So, does it means we should use negative IRR as a discount rate to calculate the present value!
Certainly not. Negative discount rate would mean money available at the present time is worth less than the same amount in the future.
With certain cash flow streams, it is possible to produce multiple IRRs. A net cash flow stream will have multiple IRRs when it Includes more than one sign change.
When the first cash flow is negative and the second cash flow is positive, that is one sign change and there will be one IRR for the stream. If another, later, net cash flow event is negative, that makes 2 sign changes. There will be one IRR for every sign change in the cash flow stream.
Now consider the following cash flow:
If we use the Excel IRR formula, we will get 6.6% as IRR. But we know that there will be two IRRs as the cash flow changes sign twice.
Now let’s calculate the NPV at different discount rates:
You will notice that the NPV changes sigh at two discount rates, i.e. NPV is zero for two discount rates. This means there is another IRR possible. This will be more clear when plot a chart:
It is obvious that there is two IRRs. We can calculate both possible IRRs by inputting the “guess” optional input in the Excel IRR function:
From the chart above, it is clear that one IRR is close to 6% and another one close to 36%. We need to calculate the IRR twice; first we need to put 6% as “guess” option input and in second calculation 36%.
We will get both possible IRRs:
So what should we do in such situation? Which IRR should consider while evaluating projects with such cash flow streams?
In my opinion, it is rational to consider the IRR which is closest to the cost of capital as the "true" IRR.
Hope you enjoyed this post on negative IRR. If you have any questions, let me know through the comment section below.
You can also download the Negative IRR Workbook FREE!