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Professor, I understood all disadvantages of IRR except this one. It would be nice of you if you explain.
-” IRR method assumes that funds can be reinvested at a rate equivalent to IRR, which may be too high.”This is only relevant if the IRR is being used to choose between 2 projects.
Suppose there is a choice between, one project that needs an investment of $1000, lasts for 5 years and gives a return (an IRR) of 10% p.a., and another project that also requires an investment of $1,000, lasts for 20 years, and gives a return (an IRR) of 9%.
The cost of capital is 5%.Which would you choose if you had $1,000 and could either get interest of 10% a year but only for 5 years, or you could get 9% a year for 20 years?
You would not choose the one giving 10% (even though it is higher than 9%) because earning 9% a year for 20 years (when the cost of capital is only 5%) would end up giving you more in total.
The only time that the one giving 10% would be better would be if it was the case that as you received money each year you could re-invest it so as to earn 10%, and in that way you would end up getting 10% per year for ever (which would be better than getting 9% a year for ever).
(The end of the sentence that says “which may be too high” is of no relevance at all!!)
I suppose you could just be expected to be aware of the disadvantage, but you could not be asked to show any calculations.
Professor, you mean to say that in IRR method we are ignoring the benefit that will arise from the life of project. We just want the project with greater IRR. Right?
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