IRR

Firstly, you say that it is unrealistic for finance providers to give such a high interest rate. That is not relevant at all. Also, IRR’s are not necessarily high at all.

For a simple accept or reject decision there is no problem. The IRR is simply the break-even interest rate (the rate at which the NPV would be zero). So if the IRR is great than the cost of capital the project should be accepted (because the NPV would be positive), and if less than the cost of capital it should be rejected (because the NPV would be negative).

The problem arises when two projects are being compared. Just because one project has a higher IRR than the other project does not necessarily mean that it is better. Firstly, there is no real logic in simply comparing ‘break evens’. Also (as a simply example) suppose one project had an IRR of 20% and lasted for 4 years, and a second project had an IRR of 19% but lasted for 20 year. (and cost of capital was 15%).
Individually both projects are worthwhile, but if you had to choose it is likely that you would prefer a slightly lower return (from the second project) because you would continue to get it for a much longer period.
When choosing between projects we should calculate the NPV’s and choose the higher one.
BUT, if we could continue to reinvest the returns at the IRR, then it would be as though we could get 20% return for ever from the first project as against 19% for ever from the second.
In that case, the first one would be the best.

So……to summarise, choosing between projects on the basis of the IRR’s would only be valid if we assumed that the returns could be reinvested at the IRR.

(For the exam, we only calculate the IRR’s if specifically asked to. All my explanation above is only relevant in the written part of a question).

You are welcome 🙂