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Dear Tutor,
I have been looking at the advantages and disadvantages of the IRR method in Kaplans Complete Text 2011. It says that non-conventional cash flows may give rise to no IRR or multiple IRRs – how can this happen ?
Also in one of the answers in the Exam Kit, it states that IRR and NPV can offer conflicting advice when it come to mutually exclusive projects – why does this happen ? In the same answer it says that IRR may offer as many IRR values as there are changes in the value of cash flows, giving rise to evaluation difficulties (which is probably related to my first question).
Please can you help? I have spent hours trying to find the answer.
Thanks
KirstyIRR is the discount rate at which NPV=0.
you would get no IRR for a cash flow which has negative NPV at all discount rate. NPV is not reaching zero at any discount rate.
you would multiple IRRs for a cash flow when NPV at different discount rate has zero value. suppose,
@5% discount rate, NPV =0,
@9% , NPV=0.,
@ 12.5% NPV=0.
at multiple points NPV =0.suppose, there are 2 mutually exclusive projects A and B such that,
A has higher NPV than B.
IRR of A is lower to B.in this case, IRR method would suggest project B and NPV method would suggest project A. project A is actually better than project B because it has higher NPV.
suppose, project A and B has same NPV. then IRR would suggest project B as better, which is a right suggestion.
For most projects there is an outflow at the start, and then inflows.
In this case there is just one IRR.However, if you had an outflow, then inflows, then another outflow, then there could be 2 IRR’s (not always, but there could be). It is because you start of as an investor and then become effectively a borrower. (Every time the sign of the cash flows change, there is the possibility of one more IRR.)
Do not worry about the arithmetic – it is just that if you accept that there can be more the 1 IRR then making use of it becomes less obvious.
With regard to choosing between projects, you cannot simply choose the one with the highest IRR – it will not always be the one with the highest NPV. The reason is that the IRR is not really a rate of return, it is simply breakeven (i.e. NPV of zero).
So, for example, a project with an IRR of 20% which required an investment of 10,000, is not necessarily better than one with an IRR of 15% which requires an investment of 100,000. It might be better to get a lower return on a much bigger amount, than a higher return on a much lower amount.
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