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Hello Sir,
Could you kindly explain these two statements relating to IRR?
1: It is used when there is uncertainity about cost of capital.
2: It is an estimate based on interpolation so any projects having senstive returns maybe subject to wrong decisions.
Thank you.
1 The IRR is a result of the pattern of cash flows and the cost of capital is not needed to calculate it (unlike calculating the NPV). However, having found the IRR, it needs to be interpreted and used for decision-making. This is done by comparing it to the cost of capital. If IRR > CC then the project should be accepted. So, I’m not at all convinced 1 is a correct statement in all circumstances. However, if the IRR were very high so that it was greater than any likely CC it would be useful.
2 IRRs are usually calculated by working out the NPV at two discount rates then putting the figures into the IRR formula. If you chose 8 and 12 as the two discount rates you might get an IRR of 10.2%. However, if you had chosen discount rates of 5 and 20 you might get an IRR of 9.8. Both IRRs are approximations of the true IRR. If the cost of capital is 10% one IRR would lead you to accept the project but the other would lead you to reject the very same project.
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