Question

a) List and explain three problems with IRR, and whether or not MIRR solves each problem. Your explanation should include why these are problems (why we can't just ignore these issues).

b) List and explain (in one to two sentences each) two problems with payback period that are not problems for NPV. Your explanation should include why these are problems (why we can't just ignore these issues).

c) There are three characteristics that we need to know about a project's cash flows in order to properly value them (correctly calculate the present value). Name the three things, and briefly explain why we need to know each characteristic.

Answer 1

(a) Problems with IRR

1) IRR is that rate at which NPV of the project is zero i.e. present value of cash inflows equals present value of cahs outflows. However, when a project has varying time spans for cash flows i.e. one duration for positive cash flow and another duration for negative cash flow, IRR gives two rates. MIRR overcomes this problem as MIRR considers considers terminal cash inflows

2) If projects are mutually exclusive which means if one project is to be selected then other project will have to be skipped. In this case IRR method suggest that project with High IRR should be accepted but IRR method does not consider the volume of cash inflows i.e. economies of scale. MIRR method does not overcome this problem as like IRR , MIRR also takes decision on the basis that project with highest MIRR should be selected MIRR,too, ignore the size of the NPV: e.g. project A has IRR of 8% and NPV of 2000 whereas Project B has IRR of 6 % and NPV of 4000 , in this case both IRR and MIRR would lead to rejection of Project B though Project B should be selected as having high NPV of the two projects.

3) IRR takes into consideration internal factors and does not consider cost of capital or rate of inflation as this rate is found internally taking into account cash outflow in the beginning of the project and cash inflows of the project. This problem can be overcomed by using MIRR which takes into account cost of capital i.e. rate of return is calculated on the basis of cost of capital.

These problems with IRR cannot be ignored because these may lead to selection of a project which otherwise would have not been accepted if other methods had been used.

(b) Two main problems with Pay Back Period Method

1) It does not take into consideration time value of money and this problem cannot be ignored as generally projects involve huge investments and particularly if they are to be run for longer periods, pay back period method may lead to wrong decision about acceptance or rejection of the project.

2) Another major problem with this project it ignores the cash flows which arise after pay back period which may lead to misleading evaluation of the project.

(c) Three characteriestics which should be known about cash flows

1) Timing of the cash flow While considering cash flows it should also be noted that whether more amount of cash flows is occuring at early years of investment or later years of investment. projects generating cash flows during early years of investment should be preferred to projects generating cash flows at later years other things remaining the same.

2) Size of the cash flows should also be considered along with timing of the cash flows. This means cash flows of large size (more amount) should be preferred to cash flows of small size in early year as with passage of time value of money decreases so later cash flows will give generate less value.

3) Opportunity costs should also be considered i.e what would be amount, timing and present value of cash flow if investment would have been made in some other project or opportunity available.