LOS d: Explain the potential problems in using IRR as a measurement tool in real estate investments.

Q1. Which of the following statements regarding the evaluation of mutually exclusive projects using the NPV and/or IRR approaches is FALSE?

A)   Whenever a conflict exists between the IRR and NPV approaches, the project with the highest IRR should be selected.

B)   Multiple IRRs are likely to exist when there is a relatively large change in the direction of investment’s cash flows.

C)   Ranking conflicts between the IRR and NPV methods are likely to result when the projects being evaluated have relatively large differences in the size of their cash flows.

Q2. Which of the following statements is most accurate regarding the evaluation of real estate investments that require relatively large cash expenses during the life of the investment?

A)   Multiple internal rates may occur.

B)   The recommendation of the IRR and NPV methods are likely to conflict.

C)   The IRR and NPV evaluation methods will conflict at relatively low discount rates.

Q3. Which of the following cash flow streams is most likely to have multiple IRRs?

Purchase Price               Cash Flow 1                   Cash Flow 2

A) $1.0 million           $1.0 million gain        $0.1 million expense

B) $1.8 million          $10 million gain         $9 million expense

C) $1.7 million           $8.0 million gain         $5 million gain

Q4. An investment consortium is evaluating two mutually exclusive real estate investment opportunities: a multi-unit apartment complex, and a local shopping center. This investment group requires a 9% after-tax return on equity capital. For the apartment complex, net present value (NPV) and internal rate of return (IRR) analysis result in an NPV of USD7.5 million and an IRR of 11%. For the shopping center, the NPV is USD6.8 million and the IRR is 14%. If the investors require an after-tax return of 9% on either investment, which of the two investments should be undertaken?

A)   The apartment complex because it has the highest NPV.

B)   The shopping center should be selected because it has the highest IRR.

C)   Both investments should be undertaken because they both have positive NPVs and their IRRs exceed the required return on equity.

LOS d: Explain the potential problems in using IRR as a measurement tool in real estate investments. fficeffice" />

Q1. Which of the following statements regarding the evaluation of mutually exclusive projects using the NPV and/or IRR approaches is FALSE?

A)   Whenever a conflict exists between the IRR and NPV approaches, the project with the highest IRR should be selected.

B)   Multiple IRRs are likely to exist when there is a relatively large change in the direction of investment’s cash flows.

C)   Ranking conflicts between the IRR and NPV methods are likely to result when the projects being evaluated have relatively large differences in the size of their cash flows.

Correct answer is A)

Whenever a conflict exists between the IRR and NPV approaches, the project with the highest NPV should be selected.

Q2. Which of the following statements is most accurate regarding the evaluation of real estate investments that require relatively large cash expenses during the life of the investment?

A)   Multiple internal rates may occur.

B)   The recommendation of the IRR and NPV methods are likely to conflict.

C)   The IRR and NPV evaluation methods will conflict at relatively low discount rates.

Correct answer is A)

When there is a reversal in the signs of the investment’s cash flows, it is likely that multiple IRRs will exist. This renders the IRR evaluation approach ineffective.

Q3. Which of the following cash flow streams is most likely to have multiple IRRs?

Purchase Price               Cash Flow 1                   Cash Flow 2

A) $1.0 million           $1.0 million gain        $0.1 million expense

B) $1.8 million          $10 million gain         $9 million expense

C) $1.7 million           $8.0 million gain         $5 million gain

Correct answer is B)

When there is a reversal in the sign of the cash flows, it is likely that there will be multiple IRR solutions. In fact, for the cash flow stream {-1.8; 10; -9} the IRRs are 13 and 343%.

Q4. An investment consortium is evaluating two mutually exclusive real estate investment opportunities: a multi-unit apartment complex, and a local shopping center. This investment group requires a 9% after-tax return on equity capital. For the apartment complex, net present value (NPV) and internal rate of return (IRR) analysis result in an NPV of USD7.5 million and an IRR of 11%. For the shopping center, the NPV is USD6.8 million and the IRR is 14%. If the investors require an after-tax return of 9% on either investment, which of the two investments should be undertaken?

A)   The apartment complex because it has the highest NPV.

B)   The shopping center should be selected because it has the highest IRR.

C)   Both investments should be undertaken because they both have positive NPVs and their IRRs exceed the required return on equity.

Correct answer is A)       

Since the projects are mutually exclusive, only one may be selected. When ranking conflicts exist between the IRR and NPV approaches, the project with the highest NPV should be selected