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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

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

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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