Question

Which of the following statements is CORRECT?
A) One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
B) One defect of the IRR method is that it does not take account of the time value of money.
C) One defect of the IRR method is that it does not take account of the cost of capital.
D) One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.
E) One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

Answer 1

Internal Rate of Return is the rate of return that makes the net present value of all cash flows of a certain investment equal to zero. It is helpful in comparing investments and making capital budgeting decisions.

If the internal rate of return is higher or equal to the cost of capital, the project should be accepted. If the internal rate of return is lesser than the cost of capital, the project should be rejected.

One disadvantage of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

Hence, the answer is option e.

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