When calculating the Internal Rate of Return (IRR), it’s essential that negative cash flows occur before positive cash flows. This is because the IRR calculation assumes that all cash flows are reinvested at the same rate as the IRR, and if there are positive cash flows happening before the negative ones, it becomes unclear what rate to use for reinvestment. Additionally, having positive cash flows before negative ones can lead to multiple IRR solutions, resulting in incorrect results.
Furthermore, in real-world scenarios, it’s highly unlikely that positive cash flows would happen before negative ones. For instance, when a company invests in a new project, they first have to incur costs on research and development, construction, and other upfront expenses before generating revenue. Hence, negative cash flows should come first, followed by positive ones.
Ensuring that negative cash flows happen before positive ones is crucial to achieving accurate results when using the IRR calculation.
