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IRR is not a clear decision rule because the decision depends on the shape of the IRR curve. There could be several IRRs and whether the IRR needs to be higher or lower than the cost of capital depends on the project cash flows.
I thought that the IRR was a better investment appraisal (and a clear decision rule) unlike appraising investments using their NPVs. Please clarify.
“…whether the IRR needs to be higher or lower than the cost of capital depends on the project cash flows.”
I thought that to accept a project, IRR would have to be higher than the cost of capital to make the project worthwhile (from a financial point of view). When would a project with higher IRR than the cost of capital be worthwhile and how does the project cash flow play into it all?
Thank you
IRR is not a better rule at all. The only definition of the IRR is that it is the rate of interest at which the NPV is zero. So for a conventional project (one required outflows initially followed after by inflows) if the cost of capital is less than the IRR then the NPV will be positive and if the cost of capital is more than the IRR then the NPV will be negative. For an accept or reject decision, IRR gives the same decision as NPV. The benefit of IRR is that it gives a margin for error when we are not certain of the cost of capital (as is always the case in practice).
The problems with the IRR is that firstly it will not always give the correct decision when choosing between projects – the best is the project with the higher NPV, which is not necessarily the one with the highest IRR.
Secondly, if the flows are not conventional, then for every change of sign in the flows there is potentially one more IRR/breakeven. (So if for example there was an outflow at time 0, followed by an inflow at time 1, followed by an outflow at time 2, then the sign of the flows changes twice and there are potentially 2 IRR’s). The reason is that we start of being an investor but then change to being a borrower.
You cannot in the exam be asked to calculate IRR’s when there is more than one, but are expected to be aware that this is a possible problem with using IRR’s.
I suggest that you watch my free lectures (and if needed the relevant lectures for F2, because this is revision from F2).
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