Examination Number: B102121

Name of Course: Introduction to Corporate Finance

Name of Course Organiser: Dr. Peter Moles Commented [G1]: Inserted: .

Submission Date: 7 October 2017

Word Count: 621

MEMORANDUM ON INTERNAL RATE OF RETURN (IRR) PROBLEM IN

PROJECT EVALUATION
MEMORANDUM

TO: John Doe, Chief Financial Officer of Square-It Corporation Inc.

FROM: Nik Marina Binti Nik Ahmad Kamal (s1687212)

DATE: 6 October 2017

SUBJECT: Internal Rate of Return (IRR) Problem in Project Evaluation

After careful deliberation and having gone through corporate finance course, I am

contemplated on IRRs ability to be the best measure of merit in evaluating my project. Thus,

I recommend using Net Present Value (NPV) method instead. The NPV rule states that

projects are only to be accepted with the positive and highest NPV (Berk & DeMarzo, 2011).

Advantages of IRR rule

It is understandable that the IRR rule is crucial in indicating how sensitive the investment

decision is to uncertainty in the cast of capital estimate. Managers prefer using IRR because it Commented [G3]: Deleted:d

is easier when comparing it to the estimated cost of capital. On top of that, the rule gives the

actual returns of money investors invest today. Other than that, the IRR takes into the

evaluation of the project's worth and risk involved (Kaushal, n.d.). Commented [G2]: Inserted: the

Disadvantages of IRR rule

First, IRR rule suffers a pitfall when there is delayed investment. A delayed investment Commented [G4]: Inserted: i
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occurs when theres a positive cash flow upfront followed by negative cash flows. Yet, the

IRR rule states we are to accept a project if the IRR is greater than the cost of capital that is if

all the negative cash flows occur before the positive cash flows. Therefore, the IRR rule can

incorrectly suggest that the project is accepted when the NPV decision rule states otherwise. Commented [G5]: Inserted: is
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Besides that, it can provide conflicting answers for two or more mutually exclusive projects
when there are multiple IRRs. Just as such case happens, the IRR rule is no longer applicable

leaving the NPV rule as the only choice left. Furthermore, when theres non-existent IRR.

This happens when a project receives initial payment upfront and additional payment at the

end of the projects lifespan; making the IRR rule to be incompetent to provide any guidance

while NPV rule can present its findings (Berk & DeMarzo, 2011).

Advantages of NPV rule

The NPV method gives great importance in the profitability and risk factors of the project.

Other than that, it considers of before and after stream of cash flow over the projects tenure.

Moreover, it assumes cash flows are discounted at a more conservative discount rate; making

the estimated value to be as close to the actual value. Commented [G8]: Inserted: a

Disadvantages of NPV rule

However, the NPV has its shortcomings as well. It can only advice to accept the project that

provides positive NPV but not at what period the company will receive positive NPV. Also,

the NPV rule ignores any value that the project may have. For example, if the project is

currently having a negative cash flow but it may have the possibility to expand in the

upcoming years. Obviously, this should be incorporated into the NPV rule but it is not

(Kaushal, n.d.).

Conclusion

NPV rule is more reliable when evaluating two or more mutually exclusive projects, delayed

investment and non-existent IRR compared to IRR method. Where the IRR rule fails to

perform, the NPV rule raises to the occasion. Even if IRR is preferable in our industry as

managers are working with a more intuitively appealing rate of return, I still believe using the
NPV rule display the best figure of merit. This is because, it provides realistic assumptions Commented [G9]: Inserted: a

and a better measure of profitability (Kaushal, n.d.). Commented [G10]: Inserted: a

I will be glad to discuss this recommendation with you later and follow through on any

decisions you make.

Thank you for your cooperation.

Best,

Nik Marina Binti Nik Ahmad Kamal

References
Berk, J., & DeMarzo, P. (2011). Corporate Finance. Boston: Pearson Education.
Kaushal, N. (n.d.). NPV VS IRR. Retrieved from WallStreetMojo:
http://www.wallstreetmojo.com/npv-vs-irr/