Select one disadvantage of IRR as a capital budget method.
A It can obscure the planning of mutually exclusive projects if one project has a higher IRR and another has a higher NPV.
B Projects of similar durations are not easily compared using IRR.
C It is only useful with projects that have negative cash flows.
D It involves complex calculations that are not always reliable.
The Correct Answer and Explanation is :
The correct answer is:
A. It can obscure the planning of mutually exclusive projects if one project has a higher IRR and another has a higher NPV.
Explanation:
The Internal Rate of Return (IRR) is a popular method used in capital budgeting to assess the profitability of potential investments. It is defined as the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Despite its widespread use, IRR has several limitations, particularly when it comes to comparing mutually exclusive projects.
When deciding between mutually exclusive projects, it’s critical to choose the one that adds the most value to the firm. However, a project with a higher IRR does not necessarily mean it is the more valuable project. This is because IRR can be misleading in certain situations:
- Scale of investment: IRR does not consider the scale of the investment. A smaller project may have a higher IRR but contribute less overall value compared to a larger project with a lower IRR.
- Timing of cash flows: IRR assumes that all cash inflows are reinvested at the same rate as the IRR. This assumption can be unrealistic, as the reinvestment rate may differ significantly from the IRR, especially in fluctuating economic environments.
- Different cash flow patterns: Projects with different cash flow patterns can yield different IRRs, making direct comparisons difficult. For example, a project with early large inflows may have a higher IRR compared to one with more evenly distributed inflows, even if their overall NPV is lower.
- NPV vs. IRR: When comparing mutually exclusive projects, the decision rule based on NPV can lead to a different choice than the one based on IRR. This discrepancy arises because while NPV directly measures the value added to the firm in currency terms, IRR indicates the rate of return on each dollar invested for the duration of the project. The project with the highest NPV is usually the preferable choice, as it increases the firm’s wealth by the greatest amount, regardless of the project’s IRR.
Therefore, the reliance on IRR alone can obscure the planning process, especially when projects are mutually exclusive, because it does not always align with the goal of maximizing shareholder value, which is better achieved by focusing on NPV.