Question

Using Internal Rate of Return (IRR) for analysis can be flawed because a. the discount rate can be overstated b. project cash flows are expected to be reinvested at the internal rate of return c. the project's cash flows can be back loaded d interest rates can change over time for extended projects e it is generally easier to understand a project's Net Present Value rather than its Internal Rate of Return

Answer 1

Internal rate of return (IRR) can be flawed because of its very assumption that the projected cash flows can be reinvested at the rate of IRR.

This assumption is not practical and may not hold valid. For example, If in year 1, the IRR of the project is 10% then the reinvestment will be done at the rate of 10% and when the IRR falls to a lower level, say 7% in year 2, then the reinvestment will be done at the rate of 7%. It is not always possible to get the same investment opportunities. Say, if the reinvestment is done in year 1, then the market rate of return may be higher and reinvestment can be done at the rate of 10% but in subsequent years there is no surity that the investment climate will be in accordance with the IRR rate.

Hence the correct answer is B.