Reading 6: Discounted Cash Flow Applications-LOS a, (Part 3) class, div, following, problems, return

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Session 2: Quantitative Methods: Basic Concepts
Reading 6: Discounted Cash Flow Applications

LOS a, (Part 3): Identify problems associated with the IRR rule.

 

 

 

Which of the following is NOT a problem with the internal rate of return (IRR)?

A) Non-normal cash flow patterns may result in multiple IRRs.

B) A higher IRR does not necessarily indicate a more-profitable project.

C) Sometimes the IRR exceeds the cost of capital.

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If the IRR exceeds the cost of capital, that merely indicates that the project is acceptable—this is not a problem associated with IRR. Non-normal cash flow patterns such as cash outflows during the project's life can result in multiple IRRs, leaving open the question as to which one is valid. A higher IRR will only be realized if the project’s cash flows can be reinvested at the IRR, and the true profitability of a project also depends on project size, not just IRR.

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Which of the following is least likely a problem associated with the internal rate of return (IRR) method for making investment decisions?

A) An investment project may have more than one internal rate of return.

B) IRR and NPV criteria can give conflicting decisions for mutually exclusive projects.

C) The IRR method determines the discount rate that sets the net present value of a project equal to zero.

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The IRR method equates an investment’s present value of inflows to its present value of outflows. The IRR by definition is the discount rate that sets the net present value of a project equal to zero. Therefore, the decision rule for independent projects is as follows: if the IRR is above the firm’s cost of capital, the project should be accepted, and if the IRR is below the cost of capital, the project should be rejected.

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Sarah Kelley, CFA, is analyzing two mutually exclusive investment projects. Kelley has calculated the net present value (NPV) and internal rate of return (IRR) for each project:

Project 1: NPV = $230; IRR = 15%

Project 2: NPV = $4,000; IRR = 6%

Kelley should make which of the following recommendations concerning the two projects?

A) Accept Project 1 only.

B) Accept Project 2 only.

C) Accept both projects.

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Because the investment projects are mutually exclusive, only one project can be chosen. The NPV and IRR criteria are giving conflicting project rankings. When decision criteria conflict, always use the NPV criteria because NPV evaluates projects using an appropriate discount rate, the weighted average cost of capital. The IRR may not be a market rate, therefore future cash flows associated with the project may not be capable of earning a rate of return equal to the IRR.

bmaggie

The internal rate of return (IRR) method and net present value (NPV) method of project selection will always provide the same accept or reject decision when:

A) the projects are mutually exclusive.

B) the projects are independent.

C) up-front project costs are under $1.0 million.

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If a project’s IRR exceeds the cost of capital, the project’s NPV will be positive. The only way in which accepting a positive NPV project would reduce firm value is if its selection precludes selection of a project that would have enhanced firm value to a greater extent (i.e., had a higher NPV). IRR and NPV method accuracy do not depend upon project duration or costs.

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