Quantitative Methods - The Internal Rate Of Return And Net Present Value Flashcards
What is the IRR used for?
The med for assessing the total return from an investment or a portfolio, and you will find this approach necessary when calculating the gross redemption yield for a bond or the money-weighted return for portfolio performance
What is the relationship between net present values and required rate of returns?
An inverse relationship exists, as one goes up, the other goes down
What is the IRR?
The rate of interest that discounts the investment flows to a net present value of zero
When comparing alternatives, which is superior! IRR or NPV
NPV
What are the assumptions and limitations of the IRR calculation?
Cash flows expected to accrue from any investment can be considered in isolation, and are independent of decisions relating to any other investment
Cash flows are known with certainty
No firm or individual has sufficient funds to affect the price of funds
Investors have a time preference for money and make rational decisions accordingly
What is the fundamental difference between IRR and NPV?
Under NPV we assume implicitly that any surplus funds generated can be reinvested to earn a return equal to the required rate of return
The IRR calculation assumes that surplus funds will be reinvested to earn a return equal to the IRR, that the time value placed on money is this rate
Conceptually why is NVP superior to IRR?
Regardless of the actual investment that is generating the cash flows, we always assume the flows can be reinvested at the same rate. There is no real justification for saying that returns from one investment can be reinvested to earn a return in excess of the returns earned from any other investment, as assumed with the IRR
What happens if there are multiple sign changes in a series of cash flows , inflow, outflow etc
The IRR decision rule may be impossible to implement
