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($50,000.00)

Discount Rate

The internal rate of return (in real terms) on this project is 18.06%, which is higher than

the real cost of equity of 11.40%. Again, these results are consistent with the findings

from the NPV rule, which also recommended accepting this investment.

Biases, Limitations, and Caveats

The internal rate of return is the most widely used discounted cash flow rule in

investment analysis, but it does have some serious limitations.

11 The terminal value of the project itself is a function of the discount rate used. That is why the IRR

function in excel will not yield the right answer. Instead, the net present value has to be recomputed at

every discount rate and the IRR is the point at which the NPV=0.

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Since the IRR is a scaled measure, it tends to bias decision makers towards smaller

â€¢

projects, which are much more likely to yield high percentage returns, over larger

ones.

There are a number of scenarios where the internal rate of return cannot be computed

â€¢

or is not meaningful as a decision tool. The first is when there is no or only a very

small initial investment and the investment is spread over time. In such cases, the IRR

cannot be computed, or, if computed, is likely to be meaningless. The second is when

there is more than one internal rate of return for a project, and it is not clear which

one the decision maker should use.

Illustration 5.18: Multiple IRR Projects

Consider a project to manufacture and sell a consumer product, with a hurdle rate

of 12%, that has a 4-year life and the following cash flows over those 4 years. The

project, which requires the licensing of a trademark, requires a large negative payment at

the end of the fourth year. Figure 5.7 shows the cashflows:

Figure 5.7: Cashflows on Investment

The net present value profile for this project, shown in figure 5.8, reflects the problems

that arise with the IRR measure.

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Figure 5.8: NPV Profile for Multiple IRR Project

$80.00

$60.00

$40.00

Internal Rates of Return

$20.00

$0.00

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NPV

($20.00)

($40.00)

($60.00)

($80.00)

($100.00)

($120.00)

Discount Rate

As you can see, this project has two internal rates of return - 6.60% and 36.55%. Since

the hurdle rate falls between these two IRRs, the decision on whether to take the project

or not will change depending upon which IRR is used. In order to make the right decision

in this case, the decision maker would have to look at the NPV profile. If, as in this case,

the net present value is positive at the hurdle rate, the project should be accepted. If the

net present value is negative at the hurdle rate, the project should be rejected.

Multiple IRRs: Why They Exist And What To Do About Them.

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