If choosing between projects, then selecting the one with the highest IRR is only valid if we assume that as we get inflows then they can be reinvested at the IRR so that we get that return for ever.
(You will not be required to elaborate in the exam, but this is explained more in paper F9)

You would not be asked to show that with calculations.

What we should really say is that choosing between investments on the basis of the IRR’s is assuming that we can continue to keep getting the IRR indefinitely – i.e. that receipts are reinvested at the IRR.
Since that is not normally the case, we should either choose between investments on the basis of NPV, or calculate the MIRR which in a sense ‘cheats’ to give the correct decision.

Suppose you have $100,000 to invest. There are two choices – you can invest all $100,000 at 10%, or you can invest just $10,000 at 20% (and not be able to invest the other 90,000 anywhere). Surely you would prefer to invest all at 10%. The other investment gives a higher return, but overall you would end up with less.

May I ask the reason why there might be more than 1 IRR for project? I don’t quite understand this part on the problem arising from IRR. May you please elaborate on this part? Since IRR is calculated using 2 cost of capital and then the formula using the linear relationship in fact it isn’t. But it does not explain that there might be more than 1 IRR unless you use a different discounting factor which might end up with a slightly different result?

If you draw a graph of the NPV against the rate of interest, then usually it is a downward sloping curve and there is just one IRR.
However, you can have the situation when the curve goes upwards, then turns and goes downwards and crosses the axis twice – i.e. 2 internal returns.

Basically, for every change of sign in the cash flows there is one more potential IRR.

Usually there is an initial outflow followed by inflows – i.e. 1 change of sign, and therefore just 1 IRR.
However, if there was an outflow followed by inflows then followed by another outflow, then there could be 2 IRR’s (there won’t necessarily be 2, but there could be).

You will not be asked about this except insofar as it is one possible problem with using IRR’s.

For more, you need to watch the F9 (and F2) lectures on IRR. However it isn’t really worth bothering about. The only place it stands to be relevant in P4 is a point that could be worth mentioning if you are every writing about the IRR. Yu are never asked any arithmetic on this point.

No – we do not email copies of the videos.
Streaming is temporarily offline at the moment due to a problem – it will be back soon, so please try again later.

thank you. I actually didnt notice the server is down. i just want to say thank you for opentution team that really make me eager to learn P4. i understand everything. thank you.

Amer says

I didn’t understand the sentence ” IRR assumes cash will be reinvested at IRR” could you please elaborate?

John Moffat says

If choosing between projects, then selecting the one with the highest IRR is only valid if we assume that as we get inflows then they can be reinvested at the IRR so that we get that return for ever.

(You will not be required to elaborate in the exam, but this is explained more in paper F9)

abdelbagi2004 says

thanks

John Moffat says

You are welcome 🙂

sohail says

Sir,

How exactly IRR assumes that receipts are reinvested at IRR? How can we show that with calculation?

John Moffat says

You would not be asked to show that with calculations.

What we should really say is that choosing between investments on the basis of the IRR’s is assuming that we can continue to keep getting the IRR indefinitely – i.e. that receipts are reinvested at the IRR.

Since that is not normally the case, we should either choose between investments on the basis of NPV, or calculate the MIRR which in a sense ‘cheats’ to give the correct decision.

sohail says

Got it. Thanks

Nasrullah says

please explain me the line cant compare projects using IRR.I did not understand that line.

John Moffat says

Here is just one example of the problem:

Suppose you have $100,000 to invest. There are two choices – you can invest all $100,000 at 10%, or you can invest just $10,000 at 20% (and not be able to invest the other 90,000 anywhere). Surely you would prefer to invest all at 10%. The other investment gives a higher return, but overall you would end up with less.

davisyieh says

Hi Sir,

May I ask the reason why there might be more than 1 IRR for project? I don’t quite understand this part on the problem arising from IRR. May you please elaborate on this part? Since IRR is calculated using 2 cost of capital and then the formula using the linear relationship in fact it isn’t. But it does not explain that there might be more than 1 IRR unless you use a different discounting factor which might end up with a slightly different result?

John Moffat says

If you draw a graph of the NPV against the rate of interest, then usually it is a downward sloping curve and there is just one IRR.

However, you can have the situation when the curve goes upwards, then turns and goes downwards and crosses the axis twice – i.e. 2 internal returns.

Basically, for every change of sign in the cash flows there is one more potential IRR.

Usually there is an initial outflow followed by inflows – i.e. 1 change of sign, and therefore just 1 IRR.

However, if there was an outflow followed by inflows then followed by another outflow, then there could be 2 IRR’s (there won’t necessarily be 2, but there could be).

You will not be asked about this except insofar as it is one possible problem with using IRR’s.

For more, you need to watch the F9 (and F2) lectures on IRR. However it isn’t really worth bothering about. The only place it stands to be relevant in P4 is a point that could be worth mentioning if you are every writing about the IRR. Yu are never asked any arithmetic on this point.

davisyieh says

Hi Sir John,

Thanks for your prompt and clear reply!

sogan0 says

Thank You

toobaalvi says

Why is +258-59= 317?

John Moffat says

It isn’t!

The NPV is falling from +258 to -59, so the fall is +258 – – 59 (and – – is a +)

John Moffat says

No – we do not email copies of the videos.

Streaming is temporarily offline at the moment due to a problem – it will be back soon, so please try again later.

redianna says

thank you. I actually didnt notice the server is down. i just want to say thank you for opentution team that really make me eager to learn P4. i understand everything. thank you.

nailya1908 says

Thank you very much for that you help us!

accaforall says

thanks