Internal Rate of Return Approach

Question 1

Under what conditions is the internal-rate-of-return approach (to capital budgeting) not appropriate?

Answer 1

When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.

Question 2

Identify the disadvantages of the internal-rate-of-return approach to capital project evaluation.

Answer 2

1. Difficult to compute
2. Requires estimation of cash flows over entire life of project, which could be very long
3. Requires all future cash flows be in the same direction, either inflows or outflows
4. Assumes cash flows resulting from the project are immediately reinvested at the project’s internal rate of return.

Question 3

Describe the internal rate of return (also called time adjusted rate of return) approach to capital project evaluation.

Answer 3

Evaluates a project by determining the discount rate that equates the present value of a project’s cash inflows with the present value of the project’s cash outflows.

Question 4

Identify the advantages of the internal-rate-of-return approach to capital project evaluation.

Answer 4

1. Recognizes the time value of money

2. Considers the entire life and results of the project

Question 5

Compare the internal-rate-of-return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).

Answer 5

1. The IRR Approach computes the discount rate that would make the present value of a project’s cash inflows and outflows equal to zero
2. The NPV Approach uses an assumed discount rate to determine whether or not the present value of a project’s cash inflows and outflows is positive or not