the irr rule can lead to bad decisions when course hero

What is the IRR rule?

The IRR rule states that if the internal rate of return on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued.

What is the'IRR rule'?

What is the 'IRR Rule'. The IRR rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued.

What does a high IRR on a project mean?

The higher the projected IRR on a project, and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the company. That is, the project looks profitable and management should proceed with it.

How does IRR affect the cost of capital?

The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. The IRR rule is used to evaluate projects in capital budgeting, but it may not always be rigidly enforced.

Can IRR be negative?

Negative IRR occurs when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment. In this case, the investing entity will experience a negative return on its investment.

Under what circumstances will the IRR and NPV rules lead to the same decision?

i) If the projects are independent and the cash inflow of the projects are positive without even a single negative cash flow during the life of the project both NPV and IRR will give the same result.

Under what conditions do the IRR rule and the NPV rule coincide for a stand alone project?

Under what conditions do the IRR rule and the NPV rule coincide for a stand-alone project? The IRR rule is only guaranteed to work for a stand-alone project if all of the project's negative cash flows precede its positive cash flows. If this is not the case, the IRR rule can lead to incorrect decisions.

Under what circumstances may the internal rate of return provide an incorrect decision?

The IRR rule may sometimes provide the incorrect investment decision [6-7] when (1) the firm is reviewing two mutually exclusive investments (the firm cannot invest in both; if it accepts one, it must reject the other), and (2) the project's cash-flow stream changes signs more than once (the sequence of future cash ...

What is the IRR decision rule?

The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate. The IRR Rule helps companies decide whether or not to proceed with a project.

Is NPV or IRR better for decision making and why?

IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.

Why is IRR bad for mutually exclusive projects?

IRR is sometimes wrong because it assumes that cash flows from the project are reinvested at the project's IRR. However, net present value assumes cash flows from the project are reinvested at the firm's cost of capital, which is correct.

What is the underlying cause of ranking conflicts between NPV and IRR?

The underlying cause of the NPV and IRR conflict is the nature of cash flows (normal vs non-normal), nature of project (independent vs mutually-exclusive) and size of the project. Independent projects are projects in which decision about acceptance of one project does not affect decision regarding others.

Why is there a conflict between NPV and IRR?

Ranking conflicts between NPV and IRR The reason for conflict is due to differences in cash flow patterns and differences in project scale. For example, consider two projects one with an initial outlay of $1 million and another project with an initial outlay of $1 billion.

Why should the internal rate of return IRR not be used as the decision Technique for projects with non-normal cash flows quizlet?

Why should the internal rate of return (IRR) not be used as the decision technique for projects with non-normal cash flows? Non-normal cash flows produce multiple IRRs so the accept/reject decision is questionable.

What is the decision rule for IRR quizlet?

The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. What is the relationship between IRR and NPV?

What decision rule Do managers follow when they use the IRR method to accept or reject investment proposals?

The decision rule for IRR is to accept the project if the IRR equals or is greater than the required rate of return and reject the project if the IRR is less than the required rate of return.

Why should the internal rate of return IRR not be used as the decision Technique for projects with non-normal cash flows quizlet?

Why should the internal rate of return (IRR) not be used as the decision technique for projects with non-normal cash flows? Non-normal cash flows produce multiple IRRs so the accept/reject decision is questionable.

What do we call the type of project whose accept or reject decision affects other decisions?

Mutually exclusive projects are projects that, whether accepted or rejected, do not affect the cash flows of other projects. The decision to accept or reject a project may depend on whether the project is independent or mutually exclusive. A project cannot be independent and mutually exclusive at the same time.

Which one of these is an advantage of the net present value NPV method?

Advantages of the NPV method The obvious advantage of the net present value method is that it takes into account the basic idea that a future dollar is worth less than a dollar today. In every period, the cash flows are discounted by another period of capital cost.

What is the preferred model for choosing the best of several competing projects?

The best model for choosing the best of several competing projects is: Internal rate of return.

What is the T/F rule?

T/F: the discounted payback rule has an objective benchmark to use in decision making.

What happens to the payback period when the size of the first cash inflow increases?

An increase in the size of the first of the first cash inflow will decrease the payback period, all else held constant.

Does beta have a higher IRR?

Because the cash flows are conventional, their NPV profiles cross only once, so al pha must have a steeper NPV profile, but beta must have a higher IRR .

What is the best course of action if the IRR is lower than the cost of capital?

On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.

What Is the Internal Rate of Return (IRR) Rule?

The internal rate of return (IRR) rule states that a project or investment should be pursued if its IRR is greater than the minimum required rate of return, also known as the hurdle rate .

How is IRR used?

How Is the IRR Rule Used? Essentially, IRR rule is a guideline for deciding whether to proceed with a project or investment. The higher the projected IRR on a project, and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the company.

What is the IRR of cash flows?

Mathematically, IRR is the rate that would result in the net present value (NPV) of future cash flows equaling exactly zero.

Why do companies choose a larger project with a low IRR?

A company may choose a larger project with a low IRR because it generates greater cash flows than a small project with a high IRR. Investors and firms use the IRR rule to evaluate projects in capital budgeting, but it may not always be rigidly enforced. Generally, the higher the IRR, the better.

Is IRR always higher?

The IRR rule may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company may prefer a project with a lower IRR, as long as it still exceeds the cost of capital, because it has other intangible benefits, such as contributing to a bigger strategic plan or impeding competition.

Can a company follow the IRR?

A company may not rigidly follow the IRR rule if the project has other, less tangible, benefits.