Question

what is IRR...what are the problem related to ranking mutually exclusive projects ts based on IRR as the investment criteria

Answer 1

IRR ( internal rate of return ) is used to measure the profitability on investments.

It is the rate which makes NPV of all cash flows of a project 0.

Now, understanding the question :

Mutually exclusive projects are the ones in which other projects are excluded from consideration after the acceptance of a particular project.

So, how to decide whether to use NPV or IRR to decide project?

NPV ranks the projects based on which project is adding more absolute value irrespective of its initial investment values. Therefore, it is known as absolute measure.

While, IRR ranks projects based on which project is providing best returns on investment irrespective of absolute value added. Therefore, it is known as relative measure.

The problem with IRR is

1. It assumes that cash flows can be reinvested again at the IRR. But there is no surity that similar opportunities will appear again as soon as process occurs. This kind of risk is known as reinvestment risk.

2.IRR doesn't consider investment in a project. It ranks project based on just rate of return. There can be many cases where absolute return on investment is much higher but calculated rate of return is low due to initial investment. In such cases, IRR can be misleading.