Question

Describe the problems with using the IRR statistic to evaluate capital budgeting projects. What is the solution to these problems?

Answer 1

IRR is the rate at which discounted cash inflows are equal to discounted cash outflows. In other words it is the rate which discounts the cash flows to zero

There are many problems with using IRR such as

1.The calculation of IRR is very difficult if there are more than one cash outflows between cash flows there can be multiple IRR which makes it difficult to interprete.

2.It creates a very confusing and difficult situation if there is a comparison between two projects of different inflow and outflow patterns.

3. It is assumed that under this all future cash flows are reinvested at equal rate off IRR with is not possible in real world.

4.If mutually exclusive projects are considerd as investent options with different cash outlays A project with larger fund but lower IRR contributes more to NPV and increases shareholders wealth In such a situation sole decision based on IRR may not b feasable.

here are two basic ways to overcome IRR problems.

1. The NPV method should be used for projects with uneven cash flows. In such cases there is no dilemma about which IRR is better.
2. An alternative way is to use the modified internal rate of return as a screening criterion which can eliminate the multiple internal rates of return problem.