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Hi tutor,
I did the MCQ revision questions here on this website, and couldn’t understand one of the questions:
Which of the following statements are NOT weaknesses of IRR when appraising investment?
A. It ignores time value of money
B. There can be several IRR for the same project
C. It is dependent on the cost of capital
D. Cannot be reliably used for choosing between investmentsMy answer was A + C.
IRR takes time value of money into account. And it assume returns generated from invested project are reinvested into the company based on the IRR, so it is not dependent on the cost of capitalHowever the solution gave B + D.
These are weaknesses of IRR method: several IRRs can cause confusion and IRR doesn’t facilitate comparisons between investmentsCould the question be wrong?
The answer should be A and C – I have had it corrected 🙂
(Incidentally, saying that the IRR assumes returns are reinvested at the IRR is only relevant when choosing between investments. The fact that the IRR does not depend on the cost of capital does not assume anything about reinvestment, because (by definition) it is simply the rate of interest at which the NPV is zero.)
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