What is one limitation of the Internal Rate of Return (IRR)?

What is one limitation of the Internal Rate of Return (IRR)?

• A. Works effectively with multiple inflows of cash
• B. Does not consider time value of money
• C. Assumes all cash flows are reinvested at IRR
• D. Calculates cash flows with complete accuracy

Answer: (C)

The limitation of the Internal Rate of Return (IRR) that is highlighted here is particularly relevant in understanding the assumptions inherent in the IRR calculation. IRR specifically assumes that all intermediate cash flows generated by a project are reinvested at the same rate as the IRR itself. This can be problematic because it is often unrealistic to expect that reinvestment opportunities will yield returns equivalent to the IRR. In practice, the reinvestment rate of cash flows can differ significantly from the IRR, leading to potential overestimation of a project's profitability. For example, if a project has a high IRR but the actual reinvestment rate available in the market is lower, the realized returns on investments will not meet the expected returns suggested by the IRR. This misalignment can skew project evaluation and decision-making. The other options point to different aspects or misconceptions about IRR. Some might suggest that IRR can handle multiple cash inflows well, but this capability doesn’t address the fundamental assumption about reinvestment. The claim that IRR does not take into account the time value of money is inaccurate, as the IRR calculation is based on discounted cash flows, inherently factoring in time value. Finally, while IRR provides a measure

The limitation of the Internal Rate of Return (IRR) that is highlighted here is particularly relevant in understanding the assumptions inherent in the IRR calculation. IRR specifically assumes that all intermediate cash flows generated by a project are reinvested at the same rate as the IRR itself. This can be problematic because it is often unrealistic to expect that reinvestment opportunities will yield returns equivalent to the IRR.

In practice, the reinvestment rate of cash flows can differ significantly from the IRR, leading to potential overestimation of a project's profitability. For example, if a project has a high IRR but the actual reinvestment rate available in the market is lower, the realized returns on investments will not meet the expected returns suggested by the IRR. This misalignment can skew project evaluation and decision-making.

The other options point to different aspects or misconceptions about IRR. Some might suggest that IRR can handle multiple cash inflows well, but this capability doesn’t address the fundamental assumption about reinvestment. The claim that IRR does not take into account the time value of money is inaccurate, as the IRR calculation is based on discounted cash flows, inherently factoring in time value. Finally, while IRR provides a measure