314.1
Year 0 |
Year 1 |
Year 2 |
Year 3 |
|
| A | -5000 |
2500 |
2500 |
|
| B | -2000 |
1000 |
-500 |
3000 |
1. State and fully explain all of the reasons that you might be reluctant to use IRR analysis to choose between these two projects. (3 pts)
There are 3 reasons.
-First of all, the projects have different initial investments. Thus, it is inappropriate to use IRR, which is a rate of return, to compare them. The return doesn’t tell me how much value I have added. I’d rather have 10% return on $1 million than 100% return on $1.
-Second, the cash flows do not line-up. Rate of return comparisons only work for projects that have the same timing of cashflows.
-Finally, project B has two "sign-switches." It’s cash flows go from negative to positive and then negative again. This will produce multiple IRR’s, leaving you unsure of what range of IRR’s is the positive NPV range and which range is the negative range. In other words, you won’t know if you’re using the correct IRR.
In order to get full credit on this problem, you had to explain why each reason mattered. For example "Different initial investments." is not an explanation of why you wouldn't use IRR. Imagine that your boss said "So what." and you had to explain why different initial investments were a problem.