Relevancy of IRR versus CAGR as a Decision Making Tool

Question

Why is IRR an important metric for comparing investments if CAGR can be determined?

I understand CAGR to mean the constant rate of compounded growth over a given number of years. That is, the slope of a straight line drawn from the beginning to ending values over time. And I understand IRR to mean the discount rate at which the NPV is $0, based on the specific cash flows of a project.

If those intuitions are correct, and the basic goal is to grow money as much as possible over a given period, how did IRR come to be the more predominant metric? Essentially, why care about the IRR at all if you can know or estimate the CAGR of two investments?

Thanks in advance.

Answer 1

Both have their advantages and disadvantages. IRR is more flexible as it can handle any frequency and direction of cash flows, but it is more difficult to compute (manually), can be misleading and at times there can be more than one answer.

CAGR is simple but does not handle cash flows between the initial and final value. There are ways to use CAGR within periods and then combine them, but depending on how you do that you can either bias your result on the magnitude of cash flows or be biased based on the timing of cash flows (see time weighted return), or have other biases.

So either can be useful depending on the context and what you're actually trying to measure.

Answer 2

Where CAGR is a valid metric, it's the same as IRR; the CAGR formula is simply IRR calculated with no intermediate cash flows. If you do have intermediate cash flows, then CAGR is not valid. There are special cases where it can be modified, but those modifications are of varying validity, and where they all valid, they are simply further special cases of IRR.