We know that internal rate of return (IRR) is an accurate measure of a project’s economic return only if all cash flows associated with that project are reinvested (or refinanced) at the same rate during the project’s lifetime.1
But what happens to IRR in those investment projects in which a significant ownership stake is sold to a third party? We’re seeing more of these kinds of transactions in investment projects for renewable energy. Companies develop wind and solar parks and then, once construction is complete and energy production is underway, they divest majority stakes to third parties in “sell down” or “farm out” transactions.
The use of IRR as a criterion for investment in such situations can lead to highly inflated estimates that provide no guidance on an investment’s true value creation. That’s because an intermediate sell down of ownership immediately monetizes a project’s value creation across that project’s lifetime. So even if the sell down itself is a transaction with zero net present value (NPV) and the project’s value creation remains unchanged, its IRR will typically increase.
This dynamic is illustrated in the following example (table).
Table. The use of IRR in sell-down transactions can lead to inflated estimates of value.
|Project without a sell-down1||Year 0||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8||Year 9||Year 10|
|Cash flow from operations||(100)||11.0||11.0||11.0||11.0||11.0||11.0||11.0||11.0||11.0||61.0|
|Project with sell-down of 90%1||Year 0||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8||Year 9||Year 10|
|Cash flow from operations||(100)||11.0||1.1||1.1||1.1||1.1||1.1||1.1||1.1||1.1||6.1|
|Cash from sell-down||96.6|
|Net cash flow||(100)||107.6||1.1||1.1||1.1||1.1||1.1||1.1||1.1||1.1||6.1|
1. Cost of capital, 5.5 percent.
2. Modified internal rate of return.
A project with an upfront investment of $100 generates an annual cash flow of $11 for ten years, after which it has a residual value of $50. At an NPV of $12.20, the investment clearly creates value, as underlined by its IRR of 7.5 percent, which is above the cost of capital of 5.5 percent. Now assume that after one year, a 90 percent stake in the project is sold to a third party for a price equal to the present value of the remaining cash flows. Total cash inflow in year one is now $11 plus $97 (equal to 90 percent of the present value of future cash flows of $107). In all remaining years, cash flows are scaled down to 10 percent of their original level, reflecting the new ownership’s stake in the project. The NPV is unchanged at $12.20 because the sell down is a zero-NPV transaction. But the IRR for the project has now almost doubled to 14.5 percent, falsely suggesting a significant improvement in value creation.
The higher IRR from a sell down should not be interpreted as a true, annual economic return and does not indicate that the sell down creates more value for the company. It merely reflects that the project’s ten-year NPV is now monetized in its first two years (or rather, 90 percent of its NPV).
Instead of using IRR as an investment criterion, analysts and managers are better off focusing on NPV, which always provides a more accurate measure of value creation. If some rate of return estimate is still needed, it is better to apply a modified internal rate of return (MIRR), which is less affected by intermediate sell downs.
1. For more, see John C. Kelleher and Justin J. MacCormack, “Internal rate of return: A cautionary tale,” McKinsey Quarterly, August 1, 2004.
Marc Goedhart is a senior knowledge expert in McKinsey’s Amsterdam office; Vartika Gupta is a solution manager in the New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.
For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.